There is lots of information available in today’s time with the advent of technology and a plethora of resources which make it tough for an investor to get the right information. This article is intended to provide investors with a relevant understanding of the so-called “STAR” ratings of Mutual Funds prevalent in the Mutual Fund Industry.

Indian Hockey team had won 8 Gold Medal in Olympics, 6 of them were consecutive medals from 1928 to 1956 and that too without losing any game (High performing, highly rated mutual funds) whereas in 1976 the team came at 7th position losing 3 games and even failed to qualify for the 2008 Beijing Olympics hence it is quite clear that even a highly performing team in the past can’t guarantee a medal in future.

There are a plethora of mutual funds in the Indian mutual fund industry with around 45 Asset Management Companies into operation. It is hard for an investor to pick and choose between these fund houses and the funds.

Often investors refer to various websites to search the details regarding these funds and rely on star rating options.

These research websites come up with the star ratings of mutual funds wherein based on various parameters they rate the funds – 5 stars being the best and 1 star being the worst (in most of the cases) whereas as CRISL gives 1 star to the best funds across the category and 5 stars to the less performing funds.

Just like a team that was highly rated couldn’t guarantee a similar performance in the future similar is the case with investments. A highly rated fund does not guarantee a similar return in the future instead what it does for sure is to instill confidence amongst investors.

One common mistake that investors make is to rely solely on these star ratings for their investment decisions. These ratings are based on various data points such as past returns, NAV, risk adjusted returns, liquidity, asset quality etc (quantitative) but it ignores various qualitative attributes like fund manager, asset management company processes, no. of schemes per fund manager, proportion of Asset Under Management for that fund manager etc.

As an investor one has to note following points about the star ratings of mutual funds –

1. These ratings give a lot of emphasis on past returns (e.g. CRISIL ratings give 55% weightage to active return) but past returns do not guarantee the same future returns hence it should not be a blind buy based on just star ratings.

For example, indexed funds that mimic the performance of benchmark index hardy ever will get a best star ratings as it will rarely surpass the benchmark on the contrary sectoral or thematic funds might have over performance for a long term as well and hence better rated but an investor looking only for these ratings might completely ignore the high risk that these funds bear.

2. One should not just invest in the funds because they are better rated but the investment should be in conjunction with the required goals, identified risk profile, and should fit into the overall portfolio strategy.

3. Not all 5-star funds are equal for example a 5 star rated fund in the large cap will be different from the 5 star rated funds in the mid cap or balanced fund in terms of their risk return parameters (e.g. CRISIL gives 55% weightage to active return in case of Large cap, large and mid cap, multi and mid cap whereas 55% weightage to mean return in case of small cap, ELSS funds).

Also, an investor should not ignore their suitability in the portfolio as a 5 star rated mid and small-cap fund is not suitable for an investor who is not willing to take a high risk in equities and probably a large cap fund might be more suitable in such case.

4. It’s not only about the quantitative factors that these funds are rated upon as one cant neglect the qualitative factors for example Axis long term equity fund which were one of the best performing funds and rated 5 stars consistently fro the past few years has under performed big time. Since the fund manager has left the Asset Management Company which will not be accounted for in a star rating.

5. Constant review is the key – one can’t just buy and ignore the funds even if they are best-rated funds as these ratings are dynamic and change with time hence one should keep a track of changing ratings.

The key to investing is to create one’s own buying process and own mutual fund identification process and not rely solely on the star ratings. Even different websites have different ratings for the same fund so one can’t rely solely upon these rather look for a combination of both qualitative and quantitative parameters to come to one’s own filtration and identification process.