Should you give preference to mutual fund ratings?

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Many investors make investments in mutual fund schemes based on ratings, which can be a challenging decision. The mutual fund industry offers more than 1,500 schemes, and selecting one that aligns with your goals and objectives can be a difficult task.

However, the question is whether giving priority to ratings actually helps investors in choosing the best mutual funds.

First, let’s understand how the rating of a fund is determined.

The ratings from various private agencies are typically based on Risk Adjusted Historical Returns for a specific period. These ratings compare the fund’s performance with other funds in the same category, taking into account the level of risk associated with the fund. This provides an indication of how much return a fund can potentially provide at a given risk level.

In this system, mutual funds are assigned stars based on percentiles. For example, the top 10 percent of selected funds are given a 5-star rating, while the bottom 10 percent of funds receive a 1-star rating.

Now, let’s understand what can go wrong after the rating is assigned. Mistakes can happen with any fund manager, and this can sometimes lead to poor fund performance. It’s possible that a highly-rated 5-star fund may underperform due to errors or changes in the fund manager’s strategy. It’s also possible that a very capable fund manager may leave their position, affecting the fund’s performance.

Similarly, a low-rated fund’s destiny can change. A highly skilled fund manager might join, or the fund’s asset management company (AMC) could make changes to its investment approach or processes to improve performance.

Now the question arises, what should ordinary investors do? TIW Capital’s CEO Mohit Ralhan says that investors should be aware of the parameters and methodology used for ratings. They should also assess how capable the fund manager of the scheme is, what the fund house is like, and whether its investment methodology, in other words, the investment approach, is robust or not.

Rating alone cannot provide you with a sufficient estimate of the quality of an investment instrument. You also need to see if that fund is right for your specific needs. Do you want to invest for the short term or the long term? Is liquidity more important to you or returns? How much risk can you tolerate? Only after considering these factors can you choose mutual funds tailored to your specific requirements.