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The Risk of Relying on Mutual Fund Ratings

Mutual fund ratings can often end up being less effective than many investors tend to believe. After all, they attempt to convert complex data into an easy to understand metric – a task that has a fairly varied efficiency.
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For example, mutual fund rating firms have a popular rating system (often termed as best performing mutual funds) of one to five stars to simplify complicated market and risk data into something fund buyers can comprehend: a five-star fund is better than a four-star fund, which is better than a three-star fund, and so on. With thousands of mutual funds and investment products available today, investors are starting to rely heavily on this rating system.

However, a lot of people aren’t aware that these ratings might not be very helpful and too much dependency on them may not be the right way of selecting a mutual fund.

Defining mutual fund ratings and how they are calculated

Before we delve into the pros and cons of relying on Mutual Fund ratings, let’s understand what they are and how they are calculated.

In simple terms, rankings or ratings are a way to judge and compare the best performing mutual funds in a market at any time. These rankings provide mutual fund investors with a simple method to evaluate various mutual funds. They evaluate a mutual fund on various parameters that are both qualitative and quantitative. Remember, best performing Mutual funds is a myth

How Is A Mutual Fund Rating Calculated: The Factors

The quantitative factors include the overall Mutual Fund Performance, measured by parameters such as the Sharpe ratio, Treynor ratio, and Alpha. Volatility and liquidity of the mutual fund scheme are other parameters that guide agencies.

Another important quantitative factor is Portfolio Concentration, followed by credit quality for debt funds.

The qualitative factors include the mutual fund’s reputation, fund manager track record, and investment process.

How Is A Mutual Fund Rating Calculated: The Estimation Process

This data is collected and then presented to both investors and mutual fund companies in an orderly fashion. Due to this convenience, Mutual Fund Ratings are one of the most basic parameters used by most investors who are looking to invest in the top mutual funds in the market.

Why are Mutual Fund Ratings important?

Mutual Fund Ratings are considered to be very important by a majority of mutual fund investors. Since a large number of them rely on these ratings, there are two basic reasons why they are important.

Simplification

They help in simplifying complex information and analysis into a simple metric that can be understood by many. This convenience saves time and also makes the decision-making process easier.

For example, due to the rating system, an investor’s default choice would be a 5-star rated fund, over a 3-star rated fund. So this helps investors make quick decisions based on simplified market data.

Elimination

Since Mutual fund ratings are calculated on both quantitative and qualitative factors, they help in weeding out the ‘bad apples’ in the market. This essentially includes funds with an unreliable or unsatisfactory history and overall potential. Hence, they might help mutual fund investors dodge high-risk investments.

The Risk: Why Ratings might not be as reliable as investors think

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Little predictive power

Ratings are products of hindsight bias. Hindsight bias is a psychological phenomenon that allows people to believe that they accurately predicted an event after it happened. This can lead them to believe that they can accurately predict other events.

It is a common failing of mutual fund investors, and the agencies who give out these ratings often follow this phenomenon. It’s well documented that past returns are a poor indicator of future performance and hence ratings offer little to no predictive power. Investors who invest based on ratings should account for the hindsight bias in mutual fund ratings and dig deeper into mutual funds before investing in them.

As opposed to selecting a fund according to its star rating - investors should use ratings as a way to weed out 1star and 2 star funds. History suggests that funds with low ratings tend to stay low for long periods of time.

Process of elimination turns out to be a better method than using ratings as a process of selection.

  • Incentivisation of return chasing behaviour

5-star funds tend to have the highest past returns. These ratings urge investors to chase returns as a lot of equity flows in them. Individual investors succumb to this and as a result, the return earned by an average investor is more often than not lower than the return earned by the underlying investment. This common mistake leads investors to lose out on up to 2% points of annual returns.

  • Conflict of interest

A lot of asset managers tend to stick to rating agency products. This may or may not affect the overall fund ratings.

  • Rankings often happen after an event

Star upgrades done by these agencies often happen after the performance of a mutual fund improves, and star downgrades happen when the performance falls. This is highly unreliable as it gives no hindsight into the future performance of the mutual fund that has been upgraded or downgraded.

Star downgrades are therefore not necessarily a bad thing. Most strategies or actively managed funds have periods of good and bad performance. Over-reliance on ratings makes investors switch mutual funds often - something which leads to poor long-term performance.

What To Keep In Mind With Mutual Fund Ratings

Mutual fund ratings are not completely free of risk and bias. They must not be used as the only criteria while choosing a mutual fund to invest in, and individuals should weigh other factors such as potential and stability of the fund house, and track record and retention of the fund managers.

Mutual Fund Ratings might serve as the foundation for research when one’s looking for the best options to invest in. However, they must not become benchmarks. Investors are urged to exercise more due diligence while selecting mutual funds for the best returns. It’s why Glide Invest made a Risk Tolerance Survey - so investors can make sound decisions after determining if their risk appetite indeed matches their risk tolerance. Download the Glide Invest App for more insights, and a simplified investing experience.

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