Mutual funds – Are ratings the real indicators?

When it comes to investing, most of us believe in lady luck, intuitions and fate. Successful investing is not based on destiny; it involves a right blend of logic, research, discipline and planning. Investing for returns is directly proportional to the risk tolerance of the individual. Based on the risk appetite, there are several investment vehicles available in the market to the investors. One of the most popular investment vehicles in India is mutual funds.

Mutual funds are diversified, and tend to lower your risk. It lets you invest small amounts of money, which are monitored by qualified professionals who use the invested sum to create a portfolio based on pre-defined set of goals .

Mutual fund investing guidelines that can help

Among mutual fund ratings, the most popular one is the Morningstar Risk Rating. The mutual fund ratings are generally graded on a scale of one star to five stars, one being the poorest and five being the best. These ratings have been in vogue for more than a decade and are an indicator of the fund’s performance and consistency. Also known as star ratings, it is designed to help investors to arrive at purchase decisions for their portfolios.

Mutual fund ratings can make or break the success of a mutual fund. With the rating business blossoming to a million dollar industry, the impact to the end investor cannot be ignored. While mutual fund ratings can help in arriving at an informed decision making, there are some points that need extra consideration. Read on to understand them better:

1. Higher ratings doesn’t always guarantee higher returns

In the mutual fund investment scenario, a fund with higher ratings can be illusive. Analysis of other factors in the mutual fund such as – its performance trend, immediate future returns, investment strategy, its relative risk strategy and its indicative performance in bull and bear market conditions is vital. A balanced decision taken after consideration of the variables makes the portfolio more comprehensive and sound.

2. Goal alignment and portfolio

Align the portfolio based on the time identified goals. For short term goals or financial requirements, equity investments might not guarantee returns. Majority of the investors assume that mutual funds are only about investing in equities and therefore end up investing higher amounts in equity funds. Though such funds may be rated 5 stars, they tend to be more volatile and erratic in fetching returns and are not the best bid for short term goals.

3. Fund strategy

The key to investing in mutual funds is to discern the strategy of the fund. When we buy or invest in a fund, we should understand what it does, and articulate its entry and exit strategy. This enables in evaluation of fund’s performance and to build a portfolio of funds that work together.

Each mutual fund category adopts a different strategy. The performance of a fund is also dependent on the role of the fund manager. The strategy adopted by the fund manager needs careful understanding – such as de-concentration of funds by dis investing large cap funds and increased fund flow into mid cap funds, stoppage in cash calls etc. Use diligence in deciding between large or small-cap equity/short-term or long-term bond.

4.Availability of the fund manager

The exit of the fund manager does not always signal red. Different mutual fund houses have varied investing cultures, and with the right institutional processes, the absence or unavailability of a fund manager does not carry a huge impact to the end investor. In case of a change in the fund manager it would be more prudent to keep the fund on a watch list for a couple of quarters and compare its performance rather than exiting immediately. There have also been instances were a fund has been downgraded due to the exit of its fund manager who solely managed the affairs and the past performance and star ratings get skewed.

5. Rating comparisons across time horizons

Ratings are awarded to the fund schemes, based on the performance of the portfolio for a specified period of time. The number of years the fund has been in existence and the stars earned is a performance indicator of the fund. Hence, comparison needs to be made on the basis of both factors, as a 5 star rated fund which is 10 years old is more consistent in returns than a 5 star rated, 3 year old fund.

There is no one investment plan that is fool proof. It requires informed decision making through research and structured planning. “Destiny is not a matter of chance; it is a matter of choice. It is not a thing to be waited for; it is a thing to be achieved.” – William Jennings Bryan.

If you have any comments or questions, write them in the comment box below.

Or are you interested in creating a Comprehensive Financial Plan for your financial goals?

Skip the queue by registering for your 30 Minute FREE Financial Plan Consultation. Click the ‘‘BOOK YOUR SLOT NOW!’’ button below.