5 don'ts when using star ratings

Sep 15, 2015

When hunting for a fund, star ratings are a great starting point. They provide a composite, visual measure of a fund’s historical risk-adjusted return compared to peers: in any particular category, funds clocking the top-10% risk-adjusted returns get a five-star rating, followed by the next 22.5%, 35%, 22.5% and 10%, respectively, from four to one stars.

But they can also be misleading. Here are five don’ts to consider when checking out the 5-star rated funds.

1) Don’t treat it as a blind buy.

If all you do while considering a fund for investment is going for the ones with the highest star rating, it is a grave error, but unfortunately, a common one. Just because a fund has performed brilliantly does not mean it is great one.

Whenever you come across a five-star fund, look for the drivers behind its performance. Don’t just stick to the latest numbers but get a grasp on how the fund stacked up in different market environments (bull, bear and sideways markets).

For instance, BNP Paribas Long Term Equity, an ELSS, is currently rated 5 star. Its performance between 2008 and 2010 was below average. Since 2011, it has been quite impressive. The reason? Fund manager Anand Shah joined the asset management company in the first quarter of 2011 resulting in an uptick in performance.

2) Don’t ignore your portfolio.

Not many investors make asset allocation a priority though it is crucial in determining whether or not you achieve your financial goals.

For instance, even a diversified, large cap, equity fund is a strict no-no for an investor with only a one- to two-year horizon as short-term returns from equity are always volatile, disparate and unpredictable. So even if you invest in a 5-star rated fund for such a short time horizon, you could be in for a rude shock should the market turn, or turn volatile.

Alternatively, it could be that your portfolio is already packed with mid-cap funds which are fairly good performers. So adding another mid-cap fund, even though it sports a 5-star rating, is not a great idea. It would be better to opt for a large-cap one.

3) Don’t ignore the fund’s strategy. 

Funds come in various hues and even after you have decided on whether it would be an equity or debt fund and the amount to be invested, you will have to zero in on the categories of the fund (large cap/ flexi cap/ mid and small cap/ sector / long-term bond/ liquid fund and so on).

If that’s not enough, funds within each of those categories vary greatly by nature. A mid-cap fund could be a value oriented one or a growth oriented one. A large-cap fund could be an index fund, or one that tracks its benchmark index closely (apt for a relatively-conservative risk-taker), or one that does not do so at all.

The fund manager could opt for a very concentrated portfolio or opt for a very diversified one.

Similarly, a fund may have undergone a strategy over time. So your perception of the fund may be wrong, in the sense it is based on what you once knew of the fund, not what it currently is.

4) Don’t assume all 5-star rated funds are equal.

While many investors are aware that a five-star rated large-cap fund is not the same as a five-star rated mid-cap fund, they may not be aware that this holds within a category too. Even if two funds have the same strategy, it does not necessarily mean that they are equal.

As soon as a fund completes three years in a relevant category, it gets awarded with a star rating on the basis of its three-year performance.

But as soon as it goes on to complete five years, its overall star rating becomes a mix of its three- and five-year performances, with greater weightage given to the longer-term period of five years. A similar exercise is done when a fund completes 10 years where its overall rating is a weighted average of its performances across the three-, five- and 10-year periods, with greater emphasis on the 10-year period.

The above methodology means that a five-star fund that has been in existence for three years will not be the same as a five-star fund that has been around for more than 10 years, as the latter has proved its performance across market cycles and over a longer period.

Let’s look at three funds that fall under the ‘Equity: Large Cap’ category.

Mirae Asset India Opportunities is a 5-star rated fund, but its rating is constituted from across three- and five-year periods. Axis Focused 25 has a 4-star rating based on its three-year period. Another 4-star, Franklin India Bluechip has been around for a while so three, five and 10 year periods have been taken into account.

5) Don’t ignore it once you buy it.

Funds undergo changes. The AMC may get sold out. The fund manager may quit. The fund’s strategy may undergo a change. What might have been a good fit for your portfolio once upon a time may no longer be valid.

Different fund houses have different investing cultures, with some putting an institutionalized process in place largely followed by fund managers or where teams take collective investment decisions, in which case a fund manager departure may not be a signal to rush for the exits.

But there are several cases where a star fund manager single-handedly drives investment decisions and after whom, the fund’s past performance could simply become irrelevant.

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