What the Rating of a Mutual Fund tell about its Future Performance

Do you know how most of the investors select the Mutual funds ?

Well, the go with old school method of checking the ratings. Yes, to investors ratings and number of stars mutual funds have still matter a great deal.

You can pitch in the best idea and pick up most successful research methodology, your client is most likely to go with one that has highest ratings. To them there is nothing beyond the wall of stars and ratings in this industry.

But is it wise to focus this much solely of rating ? Well absolutely not!

And here it is why:

They are not any classification system:

Today, talking about star ratings is a way of checking customer's opinions and critics regarding any product or service.

People give star rating everything these days, be it a movie or a restaurant. This new concept of star rating has overshadowed the true essence of stars. The concept of stars.

The concept of stars started with rating the top restaurants and tourist hotels. You might have heard people talking about "4 star restaurant" which used to be and still is a big thing.

The standard restaurant with basic comfort use to get one star, the comfortable one would manage to get two stars while the elite luxury hotels were on the top of the game with five stars.

The star system was used to differentiate an elite class restaurant from a normal one.

However, unfortunately with the Mutual funds, the concept of classification is no-where near them. A mutual fund with 5 stars has no extra bells if compared with the one stared mutual fund.

Is it worth to chase the Best performing mutual funds? 

When it comes to most important component of mutual funds, it is hands down its performance.

When people see a mutual fund with 5 star ratings, in their mind they develop an idea that the performance of this fund must be spectacular.

Most of the time people look at the ratings to check how it performed last year. However, what people do not understand is that this term chasing performance does not work every time.

Let's suppose that a mutual fund did exceptional good last year. Due to its amazing performance all you see is 5 star rating which is justified.

However, what you do not understand is that there is no rule or logic which explains that if a mutual fund did well last year, it is going to be equally good this year as well.

Yes, there is no guarantee that a mutual fund will perform same each there.

Similarly, a mutual fund with 1 star rating based on the performance last year might end up doing exceptionally good this year.

This is why the ratings of the mutual funds can deceive the investor and they might end up making the wrong choice just because they relied on the rating of a mutual fund.

They do not reflect asset class views:

The rating systems firstly create different categories that are based on the asset geographies and classes, and then future classifies the individual funds in categories.

Star ratings basically show relatives view of the funds that are in that category, which makes sense. Star ratings are not reflecting the rating of the house’s view on asset class. There are some rating houses that do not have a single asset class view.

In this case, if a technology fund was rated five star back in 1999 and was not a recommended to buy that fund and you still decided to go for that technology fund then it is a good one. This is something that not every retail investor understands.

Mis-Classification:

There classification of the assets is a complicated thing and can cause certain misunderstandings since the classes of assets are the arbitrary definitions.

To explain this, let's take example of the equity asset.

The class of the equity asset usually gets subdivided in the large, mid cap and the diversified. Reason or the intention to do so is basically to differentiate between the funds that are invested in the blue chip stocks vs the one that invest in smaller stocks because of risk of the size reflects.

The equity funds can be invested across size spectrum, but the question is what to do with the funds that have large cap, however can be invested 20-25% into small or mid cap stocks?

In case funds get the classification as the large cup, with the other fund that tends to stick only with the large cap stocks than that fund might look like outperforming while the small cap stocks do well. This can be a very unfair advantage or even a case of some mislabeling .

There different views by the rating houses with it come to classification of the asset class. This is the reason that different funds might be classified differently.

Mutual funds rating are more like broker's recommendation:

One of the biggest drawbacks of the mutual funds rating is that people take it more like a broker's recommending.

When someone gives some star ratings to any Mutual Funds, the investors do not look beyond that rating. They do assume that accompanying commentary is available and do not read it.

If the broker or wealth manager fails to explain the ratings and performance of a mutual fund then chances are that investor does not look in depth or beyond the rating.

Final verdict:

Mutual Funds are a good way to invest when it comes to investor who are short on time or want to pick the stocks and bonds on their own. However, choosing a mutual fund simply based on its rating can be deceiving.

Buying the mutual fund that will work for the investor takes much more than just simply checking the rating. This is the reason it is wise to not solely depend on the rating of the mutual funds.

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