Why mutual fund ratings are not recommendations to buy or sell funds

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You look at a fund’s 5-star rating. You’re pleased with it and proceed to invest in it because it’s a good fund. You want to invest in a fund, and just filter by the best mutual fund ratings to pick the winners. And why shouldn’t you? A mutual fund gets the top rating because it has performed well! No.

We don’t think that going by ratings to decide that a fund is a buy or a sell is the right approach – even while we have our own mutual fund ratings system Prime Ratings. In this article, we explain why mutual fund ratings, even one as comprehensive as ours, are not substitutes for buy-sell-hold recommendations.

Performance metrics in a mutual fund ratings system are derived from one thing only – and that’s a fund’s past returns. A fund’s returns, thus, is the primary dictator of its rating.

How mutual funds are rated

Each rating system, whether by Value Research or Morningstar or CRISIL or any other entity, uses its own defined set of metrics. So, a rating system can look at 1-month returns or 6 months, 1 year, or 3 years or any other period.

It can look at the quality of the returns itself, using the range of metrics available to measure performance. For instance, risk-adjusted return measures return generated above the risk-free rate. Standard deviation indicates how much returns fluctuate. Alpha measures returns in excess of benchmark.

A fund will score better on some metrics and worse on others, since the idea behind using such measures is to better understand performance. And yet, performance metrics are derived from one thing only – and that’s a fund’s past returns. A fund’s returns, thus, is the primary dictator of its rating. So what’s wrong, you may ask.

It is that a fund has many qualitative aspects that will not show up by measuring only returns.

  • Returns do not adequately capture the risk in a fund until such risk actually materialises.
  • Returns or ratings do not indicate if the fund is suitable for you to invest in.
  • Returns do not capture the potential of a fund’s portfolio.
  • Returns do not indicate a fund’s investment style.
  • Ratings may not show where the returns came from.
  • A rating system built on fund performance cannot identify funds that are at the cusp of changing trends – i.e, good to worsening, poor to improving – without a lag. If such changes did show up quickly in ratings, it will also mean that the rating system is short-term and will frequently see fund ratings dip or rise.

Fund ratings can’t adequately capture portfolio risks, a fund’s strategy, investment suitability of a fund, or the potential of its portfolio.

What we do with Prime Ratings

In Prime Ratings, we’re well aware that looking at return measures alone is limiting. So we extend our rating system to cover portfolio quality as well. In equity funds that can see wide differentials in market-cap allocations, for example, we consider mid-cap and small-cap exposure. Across debt funds, we look at credit risk. In hybrid funds, we look at how allocations to equity, debt, and even market capitalisation changes.

Mutual fund ratings

The methodology we adopt in Prime Ratings is far more comprehensive than other mutual fund rating systems and combines both returns and portfolio. We tailor the metrics we use to the characteristics of that category.

So Prime Ratings should be fine to go by, right? Not entirely.

Now – each fund has a score which determines its rating. To arrive at the score, we use metrics as explained above. Each metric has a weight to calculate the fund’s score. We balance these weights so that no single metric dominates the fund’s score. And so, good past returns can still mask portfolio aspects.

To get past the limitations relying only on mutual fund ratings, we have the MF Review Tool, where we blend the Prime Ratings along with various qualitative aspects to give buy, sell, and hold calls. A 3 star fund may be a hold in one category  and a sell in another category. A 4.5 star may be a hold sometimes and a buy in other categories.

We have fielded several queries from you on why there’s an apparent mismatch between our call on the fund (in our MF review tool) and its rating. This goes back to the four points mentioned in the section above, which we will detail below.

To get past the limitations relying only on mutual fund ratings, we have the MF Review Tool, where we blend the Prime Ratings along with various qualitative aspects to give buy, sell, and hold calls.

What mutual fund ratings don’t show

Ratings can find it hard to capture risks

Portfolio risk is felt the most in debt funds. For funds that go for low-rated papers, the high coupon here pumps up the fund’s returns. Any return metric will look rosy. And the picture remains thus until the credit risk materialises in the form of a severe downgrade or default. Only this will pull down returns which will then show up in ratings.

A classic example is Franklin India Ultra Short Bond. We had the fund at a 4.5-star rating in December 2019. This came about in spite of a 25% weight we had for credit risk in the category. Why? Because the fund scored on every other metric we had, even if these metrics were as diverse as loss probabilities, yields, average returns and expenses. Since the fund had faced virtually no problems in terms of credit events until then, its returns remained well above every other fund in the category. By March 2020, its risk in Vodafone started showing up, pushing ratings to 3. Yet, it didn’t look bad.

But because we saw credit risks rising, we removed the fund from portfolios we had it in as well as our recommendation list. In the review tool, we very specifically allowed the fund to be bought only if your horizon was at least 5 years and your risk appetite high. Further, we had alerted on the need to reduce exposure. All this before the closure.

In another example, consider Nippon India Prime Debt, which is at 5 stars. Our call on the fund is ‘hold and avoid fresh exposure’. This call was because we saw a 50% drop in the fund’s AUM between February and May 2020 which also resulted in high concentration in the fund’s top few holdings. In hybrid funds that take derivative calls, a high rating may still mask a high un-hedged equity exposure.

What ratings don’t show: A fund’s ratings can hide risks in a portfolio such as credit exposure or mid-cap/small-cap exposure – especially when such risk is not appropriate to that category.

Ratings do not consider a fund’s suitability

Consider credit risk funds. These are generally avoidable for any investor given the big hits they can take, and because they do not really serve the purpose of a low-risk option providing your long-term portfolio protection from losses. So though SBI Credit Risk holds a 5-star rating or Kotak Credit Risk is 4 stars, both funds are ‘holds’ in our review tool.

Similarly, we have very specific calls on conservative hybrid funds. Over the years, we have seen this category go through ups and downs and are observing a lack of consistency in any fund’s performance. This reduces confidence that the fund will help your portfolio. The top-rated fund – ICICI Pru Regular Savings – is not a buy. It’s a hold, with the condition that you need to have a 3+ holding period and keep exposure at 10%. The other funds are holds or sells. This is to ensure that you do not include funds that are highly rated, but unsuitable as investments.

What ratings don’t show: Just because a fund is a 5-star fund, it doesn’t automatically make it worthy for your requirement.

Ratings can give a false sense of security

This is an extension of the last point above. Remember that a fund’s rating is in relation to how it has fared in its category. If the category itself, on an overall basis, is not going to do well, the a highly rated fund could simply be the best performer in a basically underperforming category.

Hybrid conservative funds are one example for the same reasons explained above. Another example is dynamic bond funds, where barring the top two, the rest are highly inconsistent. Given the changing debt market and the rate cycle unpredictability, most dynamic bond funds are slipping. Or, they have credit risk. So in our review tool, dynamic bond funds are a sell or a hold except for one which is a buy. A 4.5-star is a hold, a 3.5 star is a hold.

What ratings don’t show: A fund’s high rating in a category does not mean that it’s automatically a good fund if the category itself is underperforming.

Ratings do not show a fund’s style

Investment style is more important in equity and equity-oriented funds than in debt funds. Equity funds can have growth-based investing, focused strategies, value-based strategies, blended growth and value, some that take cash calls, some that get more aggressive into mid-caps and small-caps depending on market scenario.

Funds in the same category can be high-rated and either have a similar strategy or very different ones. Axis Focused 25 and SBI Focused Equity are both top-rated and both focused. But Axis is large-cap focused while SBI has a tremendous mid-cap share. So if you simply went for a high-rated SBI Focused and a high-rated mid-cap fund, you would be taking on a lot more risk than you intended.

Axis Focused 25 and Axis Bluechip are both top-rated. And both are focused and share big portfolio overlaps. If you held both funds because they were top-rated in different categories without looking at portfolios, you’d be duplicating your portfolio. Mirae Asset Emerging Bluechip and Invesco India Growth Opportunities are both high rated in the large-and-midcap category, but the former is aggressive and the latter is less aggressive.

There is no way any mutual fund ratings system will capture the strategy the fund uses. Fund investment style is an entirely qualitative assessment that involves looking at portfolio changes in different months and market phases. More, in some markets, a fund could slide in ratings (or rise in ratings) because of its strategy like many value funds (and growth funds) are doing now.

What ratings don’t show: A fund’s rating does not capture the fund’s investment style. Unless you drill down into portfolios, you may wind up with many funds that follow similar styles.

Ratings do not capture turnarounds or potential

A good mutual fund ratings system should not see fund ratings frequently change unless it is a very short-term category like liquid funds or a unexpected event like default in a top-rated paper hits a fund. Ideally, ratings should balance long-term and short-term returns to avoid being overly influenced by either. Prime Ratings does that.

But this also means that, for funds that are picking up in performance, the ratings will take time to reflect that improvement (or decline, in the opposite scenario). So you may end up skipping a 3-star fund because you think its rating is low but could actually be an improving fund. DSP Small Cap, for example, is low-rated but has been seeing a gradual performance pick up. Or the reverse could be happening, such as with Motilal Oswal Multicap 35.

A fund may also be undergoing a strategy change. Its portfolio could be such that it is poised to take off very well over the next few months or years. All these aspects will be hard to pin down in a rating system. And all these aspects are what we consider in our review tool.

What ratings don’t show: A rating system will find it hard to capture a change in potential for a fund until such change is well under way.

How to read mutual fund ratings

Having got so far, you may wonder what the point is in even rating a fund. Mutual fund ratings are important because it shows you how your fund is doing in relation to other funds in its category. A high fund rating means that it’s performing well while a low rating shows that there are problems with the fund.

So you can use our mutual fund ratings – i.e., Prime Ratings – to understand how well your fund has done within its category. You can use it to shortlist funds to invest in. But you still need to look into more qualitative aspects to make a final decision. For that – go to MF Review Tool or Prime Funds.

Our products to pick and review funds

To build a portfolio, you need to mix funds from equity and debt – and hybrid, in some cases. Your funds should be top-quality, with clear, distinctive strategies. As you now know, mutual fund ratings alone will not help.

So, go to Prime Funds for fund recommendations. In Prime Funds, we blend quantitative and qualitative metrics to pick funds which are good fits for any portfolio. Each Prime Fund is different in what it does, so you can keep any fund duplication under control. Prime Funds covers equity, debt and hybrid, so you don’t miss any opportunity.

But should you want to go outside Prime Funds, use our MF Review Tool. You will still need to look into the fund’s strategy to avoid duplication if you’re looking for funds to invest. But you will know whether the fund is a worthy of a buy, or if it is a sell or a hold. This is useful when you already hold funds and want to review them or deploy fresh money.

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9 thoughts on “Why mutual fund ratings are not recommendations to buy or sell funds”

  1. Hi Bhavana,
    You brought out an important point – portfolio overlap. Is there a way to quantitatively know the %age of overlap between two equity funds (from different AMCs) and combine it with Prime Funds to take a decision? And even better to have a historical view of this overlap rather than the current snapshot? If there is such a tool that PrimeInvestor could provide, that will provide an additional armour to members. I don’t know if it does make a case for it.
    Thanks,
    Sreenath.

    1. Hello sir,

      It’s certainly possible to calculate portfolio overlap – take the two portfolios and the stocks common between them. Then take the lower of the weights of these stocks. That’s more or less the % overlap between the funds. But – when you’re comparing two – say, multi-cap funds, chances are the top stocks will be more or less similar. HDFC Bank, Kotak Mahindra Bank etc. Can’t do without those stocks 🙂 So you won’t get fully dissimlar portfolios.

      As far as providing overlaps as a tool goes…yes, we’ll certainly consider it. Thanks for the suggestion! Coming up with MF tools is something we’ve got on our to-do list. Just can’t put a timeline on it!

      Thanks,
      Bhavana

  2. Nice Article Bhavana. Appreciate the work you are doing.

    However, i have one question – In case of hold recommendation you have described earlier that “hold” means stop investments and choose other fund in “Buy” recommendation , but also you are giving a call like “hold – avoid fresh exposure”.

    Can you elaborate on the difference between “Hold” and “Hold – avoid fresh exposure” as per you recommendation.

    1. Thanks!

      You can have SIPs in funds marked as holds…depending on how many months are left, for example. Sp this can increase your exposure even if it is a hold. And many of you may want to continue SIPs or make more investments because the fund has delivered well for you, or it is small part of your portfolio etc. So when we qualify a hold, we’re being a lot more specific in terms of what you should definitely not do. Hope this is more clear now.

      Regards,
      Bhavana

  3. Srishyla Melkote V

    After going through your “ready-to-use portfolios”, I wrote to you a few months back asking how DIY investors can figure out a fund’s investment style and received a reply that it is not easy to figure out for lay investors and even experts like you had to dig deeper into the disclosures or seek presentation from fund managers and that one of the reasons for you not picking a fund is your being unable to figure out the style in spite of your efforts. If a fund’s investment style is so important a determinant of rating an equity fund- 1. why is it seldom written about in media (similar to yours), probably you are the only analysts repeatedly writing about and incorporating it in your recommendations and reports? 2. why don’t fund managers present this as part of their monthly disclosures? 3. why don’t all rating agencies make it a standard metric? Surely that will go a long way in helping investors avoid duplicating portfolios and make better choices of equity funds.

    1. Hello sir,

      1. Media coverage – well, to know a fund’s strategy needs analysis and understanding markets. It takes time and a lot of effort because you have to look at portfolios and changes for different months in different cycles, and relate that to market movements. This is very difficult for media to do unless they are researchers and analysts themselves.
      2. Fund documents like the SID will have some explanation on strategy. Depending on the fund house, some give detailed explanations in their presentations. But this is more a disclosure thing – unfortunately, some are better at it than others.
      3. Making fund strategy a rating metric is not possible because it is entirely qualitative. There is no way I can measure if a fund is – say, value. What defines value and growth is not black-and-white. A fund can blend both, too. I can’t measure if a debt fund that’s basically accrual takes tactical duration calls. Further, I can’t say one strategy is good and the other is bad. In ratings, I need to have definite scores. So if I’m looking at risk-adjusted returns, for instance, higher the metric, the better the score. There’s no right and wrong strategy. There’s just blending strategies in a portfolio.

      Hope this explains it better.

      Regards,
      Bhavana

  4. Dear Bhavana

    One of the best write ups ever written on MFs in general and MF ratings in particular.

    I have a small query on this. Specifically in the case of Liquid funds and Index Funds (Only Nifty 50 and Sensex funds), does the Rating have major role in choice of AMC ? I can understand that it is often said that Tracking error and Expense ratio should be looked at in Index fund – but that too within the top few fund houses does not vary substantially. So if someone wants to have an STP between a Liquid Fund and an Index – and later on some re-balancing based on Asset Allocation – sometimes one feels more comfortable having both the Liquid and Index fund from the same AMC. In such a case can fund ratings and the metrics like Tracking error and Expense ratio can be overlooked?

    Thanks
    Raspreet

    1. Thanks!

      In index funds that track the larger indices – there is actually a difference in tracking error between funds. True, it isn’t very big. So ratings don’t matter so much in the bigger index funds. In gold, it does, because the gold fund invests in the ETF which can have huge tracking errors. Expense ratio, though, is very important in index funds, because it is the one factor that can actually influence returns (and therefore tracking error).

      But when you’re using liquid funds and shifting from there to index funds – you choose the index fund first and then the liquid. It should not be the other way around. You can just choose the same AMC as the index fund. The liquid fund is only a temporary investment; and anyway, barring a few where we have a sell call, there’s not too much difference between funds.

      Regards,
      Bhavana

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