Jayant Pai | firstname.lastname@example.org
I met a prospective client earlier this week. He wanted our advice on choosing a few good mutual funds. However, he had one pre-condition. He wanted us to limit our choice only to those rated “five star” by his favourite personal finance magazine. It seems that two other advisors had previously suggested only such funds and he therefore believed that they were the best ones.
While it is true that “five-star” rated funds are good performers, it may not be appropriate to get fixated on them for the following reasons:
1. Variety: Every rater (be it a magazine, a website or an agency) uses different standards, while arriving at ratings. Hence the toppers list may vary. A fund which is “five star” as per one list may be four star under another one. Hence, a good fund may not make the cut, if a client only goes by the gold standard for funds.
2. Consistency: Rarely is a fund able to hold on to the five-star rating for a very long period. Its position in the league tables will fluctuate from time to time. Any rating usually holds only for a certain point in time and that too only in relation to its peer universe. It is not a cast-iron guarantee that the fund will remain a stellar outperformer in future too. It only helps to make an educated guess regarding future performance.
3. Suitability: The amount of allocation to equity mutual funds and the choice of funds therein, is dictated by your personal goals, willingness and ability to take risk. It may so happen that a lower rated fund may be more suitable to your individual case as compared to a higher rated fund.
4. “Crowding in” effect: It is very easy for advisors to sell “five star” rated funds as clients are already pre-sold to the idea of buying these highly rated funds. However, in case the fund attracts too much money, it may suffer from the “Winner’s Curse” syndrome by losing its nimbleness and underperforming, thereby causing disappointment all around. This is a perceptible hazard in the case of mid-cap funds.
Judging a fund on certain quantitative and qualitative parameters is a preferred option. For instance, its ability to contain downside risk, the inherent volatility of the fund, its adherence to its stated mandate, its performance under different fund managers, etc. should be given more importance as compared to the number of stars following the scheme’s name. I believe that when it comes to choosing a fund, a five-star rating is neither a necessary nor sufficient condition. What matters is whether it is a good fit in your portfolio or not.