Choosing a Mutual Fund- Why Mutual fund ratings not the best way

(Last Updated On: September 20, 2016)

Can i pick up top rated funds from Crisil or Value research and invest in them ?

How reliable are Crisil Ratings or Morningstar ratings?

I invested in top rated Crisil fund last year now the fund rating has changed should i switch? 

These are some of the questions investors keep on asking on quora as well as in my individual interactions with them. Essentially all of these questions can be rephrased into a following simple question

             Are Mutual fund ratings on their own good enough to pick up a mutual fund

 The short answer to the question is no. Let me explain why and how

Different rating agencies can rate funds differently 

I picked up top mid cap and small cap funds and tried to look at how they are rated across different rating agencies results are below.

rating-agencies

Let’ say if you pick up UTI Midcap fund because Value Research rates it 5 Star and then tomorrow you go to Crisil site you would realise what the heck it is rated 3. So what to do know which one to trust. Well, in reality, both these ratings are fine the variation comes from some differences in their methodologies and 3 rating from Crisil does not make UTI Midcap fund is an awful fund.

Ratings can change within a year

Next thing I looked at is how do ratings change from year to year for some funds. Here are the top 3 Midcap/small cap funds . If you look at the table below a fund which was top in 2014 was not top fund in 2015 so if you are investing for the long term will you be shifting funds every year. This also means ratings have a limited predictive value while they are reasonably good at analysing past performance their predictive value is not up to the mark.

READ  Confused on which mutual funds to invest in ? Here is your Step by Step guide to chose Mutual Funds in India

rating-agencies_crisil           

Ratings miss certain factors 

Ratings do not take into account adequately factors like expense ratio, profile of the fund manager and other macroeconomic indicators that can impact fund’s performance in coming times.

Way Forward, How do we pick up right fund to invest

So what are we missing what is the way forward ? Well to start with we need to rephrase the question we asked initially .When you select a fund to invest you are not buying into the rating what you are doing is choosing a fund which fits into your investment goals, so starting point should never be a Mutual fund rating. Start with a clear investment goal. Here are recommended broad steps you should follow while selecting a mutual fund

  1. Articulate your investment goal
  2. Set up your return expectations
  3. Use ratings to shortlist funds which qualify the criteria you have set up
  4. Look for consistent performances over long periods because mutual fund investments are to be done for a long haul , so it is prudent to see if a fund has performed consistently over long run

I wrote a detailed post on how to pick up a right mutual fund 

 Summary of our discussion

  • Rating agencies have limitations in predicting future performance
  • Ratings should be used to shortlist funds not to choose funds
  • Good fund selection should marry your requirements with great consistent performance over long time periods

1 Comment

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  • Reading your blog I have been more confused.. In my opinion, select some mutual funds with good past performance and start SIP..Odds ratio to good return will be more than 1

    Joy nandi 2 months ago Reply


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