Which fund to choose for goal based investments - Top rated or Top performing funds?

Mutual fund star ratings are historical analysis of the fund performance and not opinion or guarantee of the future potential of the fund

Which fund to choose for goal based investments - Top rated or Top performing funds?

Planning to go for vacation and want to book a hotel. First thing you will do is look at the hotel ratings. This rating will serve as the starting point to shortlist few good hotels and then you will check the reviews, may call the hotel owner to understand the pricing, facilities offered and then arrive at a conclusion. So just a rating won’t serve your purpose and you are likely to put in more efforts to ensure you have great stay in your vacation.

Now let’s turn to mutual funds. There are several leading companies in India which gives mutual fund star ratings. These ratings are point of attraction as it makes the process of mutual fund scheme selection hassle free. While these ratings are based on the historical risk-adjusted performance over different time periods and can provide a useful snapshot of the performance of funds vis-à-vis its peers in the same category. There is no guarantee that a mutual fund scheme with a ‘5-star rating’ will offer better returns in the long term or a scheme will 1-star rating will turn out be worst performer in future. 

The reason: mutual fund is a market linked product and it is not possible to predict the market movements and the fund performance. We all are aware of the standard disclaimer – “The past performance of the mutual funds is not necessarily indicative of future performance of the schemes”. Many times, these ratings are part of the marketing campaigns and fund performance may change over a period of time. Such underperformance can derail your journey of the goal-based investing even if they are long term goals such as retirement planning, funding children’s education and marriage etc. So, does it indicate that we should ignore the star ratings when it comes to investing for long term?  The answer is No. Rather than completely discarding the fund rating; use it as a starting point in the process of filtering mutual funds. Star rating should not be only factor of evaluation to arrive at the right choice. Instead look at quantitative and quantitative factors to evaluate the fund performance.  Though goals are long term in nature don’t forget to do regular review to see if the fund is on track to meet your goals. Let’s discuss in detail on what are star ratings and what should be the prudent steps for the investors.

Understanding star rating

Mutual fund star ratings are historical analysis of the fund performance and not opinion or guarantee of the future potential of the fund.  Most of these ratings analyses the fund's historical risk-adjusted performance compared to its peers. A fund's risk-adjusted performance is calculated in different ways: 1) Some uses fund's standard deviations; 2) Some considers mean return and volatility, active return, portfolio concentration analysis, liquidity analysis and 3) Some compares monthly/weekly fund returns to monthly risk-free return for equity and hybrid funds and weekly risk-free return for debt funds. Risk free rate is the term deposit rate of the public sector bank.For all months/weeks the fund has underperformed the risk-free return, the magnitude of underperformance is added. This helps to arrive at the average underperformance and how the fund has performed vis-à-vis its category average. The relative performance of the fund is expressed as a risk score.  Apart from this, some adjust the costs like expense ratio, loads etc. while others don’t.  Given the different rating methodologies investors should first check the fund rating procedure before using the same.

Once the rating is calculated, stars are assigned on the basis of the percentile in which the mutual fund is positioned. For instance, the top 10% funds are assigned a 5-star rating, while the bottom 10% funds are slapped with a 1-star rating. A higher rating is not a necessarily a buy signal. Superior performance of the fund may be because of the good sectoral or stock picks by the fund manager, bullish phase of the market but it does not indicate that a fund will always have 5-star rating and provide better returns. Like the year 2008 financial crisis was a classic case when the sharp downfall in the market impacted the performance of the even highly rated funds while on the flipside in 2020-21 even low rated funds have displayed superlative performance. At times high rated fund may lose its shine while a lower rated fund may bounce back over a period of time. Hence, a star rating alone cannot be sole criterion to choose the fund. Consistency of the higher rating over several quarters reflects the ability of a fund manager to generate consistent returns over the long term. Besides, some of the other key factor’s investors need to look even if the goal is distant are as follows:

Consistency of the fund performance across market cycles - Check if the mutual fund scheme has been a consistent performer vis-à-vis benchmark and peers across market cycles. For this investor need to evaluate fund performance vis-à-vis their benchmark index across bullish and bearish market phases. A fund which has consistently outperformed the benchmark and peers in the bull market and fallen less than the benchmark in the bear market emerges as a good pick.

Rolling returns and risk ratios can be useful quantitative measure - to choose the good performers. Rolling returns helps to gauge average returns of the fund in overlapping cycles and removes the point-to-point bias. Also check the risk ratios of the fund vis-a-vis its peers. Look at sharp ratio (higher the ratio better the fund), standard deviation (lower the ratio better the fund), upside and downside capture ratio (helps to analyse the fund performance against the benchmark in the bullish and bearish market). All these factors can give fair idea how the fund has performed historically.

Fund management - Fund manager, his or her experience and track record in managing funds along with the team, asset under management (AUM) and fund philosophy are some of the other factors that can govern the fund’s performance. Often change in the investment philosophy or processes or the fund manager can alter the fund’s performance. Hence, even while choosing the fund for the long-term horizon a review of the how the fund house is managing the money is crucial.

Portfolio attributes - A holistic assessment of the underlying portfolio of the fund is very important. This involves in case of equity funds analysing the sector or stock holdings, concentration of top 5 and top 10 holdings, consistent holdings and top contributor to the fund performance. In case of the debt funds, it involves analysing the credit quality of the underlying debt instruments, duration management and yield to maturity.

Investment strategy and cost involved Apart from understanding the portfolio traits, it is important to know the fund’s investment strategy as it helps to understand approach that a fund house adopts while taking investment decisions. Individuals can make use of attribution analysis to find out whether the performance of the fund was due to skill of the fund manager which worked in the favour of the fund or due to market performance. Check if the investment strategy in line with the investment goals. In addition, analyse the expense ratio, exit load as higher the cost involved more it can erode the funds’ returns.

Summing up

Fund rating and performance can serve as the initial screening process however they cannot be only factors to take investment decisions.  Even if goals are long term in nature evaluation of your own personal criteria like risk appetite, choosing right category of funds along with all the above aforementioned factors is must.  Also, mutual fund investing is an ongoing process and even the best rated funds can have periods of good and bad performance. Hence, regular review of the funds to see if they are on track to attain the target goals is very important task. Adopt a holistic selection approach to pick right mutual fund and not just look at star rating and performance.