Fund ratings, at a glance, tell you a little about the history of a fund. For many of you it’s a quick reference on whether a fund is a good one or not. PrimeRatings (Free registration required to access) is a mutual fund rating system. But it’s not simply yet another fund rating tagging on to the list of ratings that are already available. PrimeRatings’ methodology:
- uses a more diverse combination of risk and return metrics,
- looks at fund categories based on their characteristics and investment purpose and not just their SEBI-defined category,
- spreads ratings out into a smoother curve which provides better distinction between funds and circumvents the problem of a sharp jump or fall in ratings
Here’s a look into our ratings process and how we’re different.
Being selective
Not all funds are rated. Funds must meet two basic requirements: AUM and age. The cut-offs depend on the type of fund. Equity funds, for example, need a minimum 3-year timeframe of existence and an AUM of Rs 100 crore before we rate them. Index funds have a lower AUM requirement. Liquid and ultra short term funds have a far higher AUM cut-off at Rs 1,000 crore and Rs 500 crore, but have a shorter timeframe.
We have different age and AUM cut-offs because each fund type is different. Liquid and other very short-term funds certainly don’t need a long history as their nature allows us to judge performance quickly. But given their high institutional interest, a large AUM is more prudent. Equity funds, on the other hand, need a longer timeframe to judge performance but can manage deftly even in smaller AUMs.
The next eligibility criteria is the category. Sector and themed funds are not rated – themes and sectors are tactical calls. Rating these funds as 5-star or 1-star serves no purpose. One, it doesn’t shed light on the potential of a theme. Two, it can additionally mislead you into thinking a fund is good simply because it holds a high rating.
We also don’t rate categories where the number of funds are too few to show meaningful results, such as multi-asset allocation funds, US-based funds, or emerging market global funds. We don’t rate closed-end funds.
Different rating system
PrimeRatings use half-star ratings progressions in the 1 to 5 star range. That is, it’s not a simple 5-4-3-2-1 star rating system but a more graded 5★ to 4.5★ to 4★ to 3.5★ and so on until 1★. This is a key metric on which we stand apart.
There are two reasons for adopting this methodology. Firstly, it provides better distinction between fund performances. This holds especially true in categories that have several funds. When a single rating houses a large number of funds, there often is a distinct difference among the funds. For instance, consider the equity multicap category. A Kotak Standard Multicap could be rated 4★ star and so could Aditya Birla Sun Life Equity. However, the Kotak fund fares much better on all metrics. A 4.5 rating for the Kotak fund would establish this superior performance.
Secondly, it provides a more gradual shift in ratings when fund performances change. For instance, let’s say a 3★ fund begins to pick up. Instead of it jumping straight to 4, the up-move is more gradual to a 3.5★ and then to a 4★ if performance sustains. This offers a more realistic measure of a fund’s performance than a quick rating improvement. The same holds when a fund begins to falter in performance – moving from, say, 3 to a 2.5 and then to a 2 instead of a precipitous drop from 3★ to 2★.
This is important because each rating has attached to it a certain implicit understanding. A sharp rating climb or drop can be misleading in terms of understanding a fund’s performance.
Comparing it right
The second way we stand apart from other fund rating providers is the way we club similar categories and then rate them. This gives a truer picture of a fund’s performance and is far stricter than sticking to SEBI-defined categories. SEBI’s categories in both debt and equity have overlaps in terms of their characteristics and the role they play in your portfolio.
For example, there is limited distinction between a low duration fund and an ultra short duration fund. Both funds serve a 3-12 month holding timeframe. Both invest in money market instruments such as commercial papers and certificate of deposits. Both have similar return and maturity profiles. As an investor, your choice for a less than 1-year timeframe would encompass both categories. Similarly, there are several overlaps between corporate bond funds and medium duration funds in credit risk and/or maturity. The choice isn’t between categories, it is between funds that do the same thing.
Consider equity funds. A multicap equity fund could follow a value strategy. A value equity fund could be multicap in nature. A focused fund could either be large-cap oriented or multi-cap. A large-cap fund could follow a focused strategy.
Therefore, to get the true picture of a fund’s performance, these need to be compared correctly. In PrimeRatings, we put and rate comparable categories together. This ensures that funds aren’t advantaged or disadvantaged and that you have the right picture when you look at ratings. Other rating agencies do not have this approach.
Tailoring metrics
The third way we stand apart is the scoring system itself. We tailor metrics and weights for each category depending on the characteristics of that category. Using a set of metrics uniformly across equity funds, debt funds, and hybrid funds as other rating agencies do fail to consider the uniqueness of each category. Our experience in analysing fund performance over the years also shows us that each fund category is developing very differently in terms of potential, performance, and risk. They therefore need to be rated distinctly.
For example, for large-cap funds the ability to beat benchmarks across market cycles carries a higher weight as it gets increasingly tough for them to do better. For small-cap funds, however, benchmark beating is not very difficult.
In dynamic bond funds, performance across rate cycles showcases their ability to alter their portfolios to capture opportunities much more than just looking at returns. In categories where there can be vast differential in credit risks, metrics need to take such risks into account. Expense ratios are a key return differentiator in some categories but not in others.
Metrics we use also strike a balance between looking at longer term performance and recent performance. This way, the ratings do not consider data that may have turned irrelevant nor is completely swayed by recent performance.
We suggest you use ratings as an indicator as to how your fund is doing. While we address risks and returns in our rating methodology, do bear in mind that these are based purely on historical returns. While our ratings may showcase trends of turnaround or dip in performances better than others, it is not a prediction for future performance. Qualitative assessments are required in addition to quantitative metrics to make an investment or exit call. Those are considered in our fund recommendations, which will be available once we go live.
Look out for our philosophy on our other researched products soon. If you’ve not read our first one on fixed deposits in this series, here it is:
https://www.primeinvestor.in/2019/11/29/what-we-look-for-in-fds-the-primeinvestor-approach/
How to read our ratings
Based on metrics and weights, each fund has a score. The scores are rated on a curve in the distribution as in the table below.
In the below scale, 1★ indicates the lowest in terms of relative performance within the rated set, moving gradually higher to 5★. For example, 5★ funds are those in the top 5% in terms of score for the rated period. We update PrimeRatings every quarter.
18 thoughts on “PrimeInvestor ratings – how we rate funds and why we’re different”
In your recent article on hybrid conservative, icici pru savings fund was considered riskier as it has more than 50% AA rated instruments. But you had rated 5 star for the same. Bit confused on the judgement
Hello sir,
Ratings consider a variety of metrics. Credit risk is one among them. However, ratings are also relative, i.e., a fund is rated compared to others in its category. As we also noted in that article, ICICI Pru is the most consistent performer in its category and its returns are strong. Therefore, its relative score is good which reflects in its rating.
Now, having credit risk doesn’t automatically make a fund bad. It makes it unsuitable for a short-term timeframe which is why we avoid such funds. A high credit risk may not necessarily push the fund to, say, a 1 star rating provided it does very well on other metrics such as volatility and consistency. This is a good example why one shouldn’t go by ratings alone to decide which funds are good and not, because numbers can mask risks.
Thanks,
Bhavana
When your paid service will be launched ? And is it bearable to general retail investor ?
Thanks for your interest in our service! We’ll be launching the beta version of our service on 15 Jan. And yes, it is well within reach of average investors. Our aim is to make our research widely accessible.
Thanks,
Bhavana
Hi,
A couple of questions:
a) Will you also show the ratings over a period of time? Eg, if a fund moves from 5* to 3* over 2 years, can we see the trend of ratings?
b) How do you plan to assess fund manager change impact on ratings?
c) How do you factor in fund size into the ratings?
d) Some funds are far more transparent about their philosophy and have skin in the game (eg. Parag Parikh, DSP to some extent). Would you factor this in?
d) For ratings changes, will you publish separately – in a way that’s actionable – ie. not give all the ratings changes (too long a list), but give ratings changes for the top funds, where the ratings are significantly different. This gets challenging to do, but will add value.
e) One more question (which I’d asked earlier but perhaps have missed the response) – how is what you do different from what the current FundsIndia team does, in terms of methodology? They are also supposed to review the ratings periodically.
f) Is your methodology quantitative? Or not? There’s no gray area here I believe!! Either the quarterly reviews have human input (humongous work), or they don’t.
Good luck to the team, and looking forward to good quality work from you guys!
K.
Hi,
No, we’re not planning to show trends in ratings, at this time at least. I do see your points on highlighting rating changes and trends; it’s great suggestion, thanks! We’ll see how we can implement it.
Fund manager changes are not a factor we take into ratings because it’s not quantifiable. The rating system is entirely quantitative. Any impact a fund manager change has on the fund will show up in performance later and this will affect its rating. The point is, a manager change may not be eventful in some funds while for others, it could be. To give a prospective call on this – before seeing impact, I mean – would be qualitative as it goes into understanding the role of the manager, the fund’s strategies, the AMC’s processes, and the fund. Similarly, transparency, skin in the game etc are qualitative – it’s not possible to assign a score to it. All these factors, and more, come into play when we draw up our fund recommendations. These recommendations and portfolios will be out soon.
Fund size is factor in some categories where it can make a difference, and is a gating criteria for all categories. As for your question on methodology, the different metrics/criteria we use for ratings, the weights, the grading system on the score etc have all been refined further and more tailored to each category that we rate.
Hope this answers your questions! Thanks for your support and suggestions,
Bhavana