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A Time of Change

Fund ratings will keep changing in volatile markets, but investors shouldn't worry much about them

Change is upon us. Actually, change is always upon us, but in recent times the intensity of change appears to have accelerated. This was brought home to me forcefully by letters I've been getting recently from readers of our magazine and the website. We always get a certain number of letters whose writers remark upon some changed star rating that Value Research has given to a mutual fund. More and more people seem either worried or alarmed by the apparently rapid pace at which we are changing funds' star ratings.

Value Research evaluates and analyses all mutual funds and rates each one upon a one to five star scale every month. The Value Research Star Rating is based entirely on an arithmetic calculation that takes into account the returns that a fund generates and the risk it takes in generating that return. The rating is entirely objective-there is no element of opinion in it. In that sense the ratings are awarded not by our analysts but by an algorithm that we have devised and which we apply uniformly to all funds.

Therefore, if people are writing to me about more frequent rating changes and their impression is correct then it can only be the result of some real change that has taken place. To figure out this puzzle, I analysed the entire ten-year history of the star ratings we have given to equity funds and the intensity with which ratings have changed in this history.

Looking at the history of our fund ratings, I observed that both the rate of change in ratings and the absolute number of changes are both at a historic high. Of course the number of funds being rated is also much higher now but the rate of change-the ratio between the number of changes and the total number of funds is also at a historic high.

Clearly, we are living in a time of great churn in the performance of mutual funds. Funds, that have been doing better start doing worse and vice versa. I don't think this change would really surprise anyone. Many fund managers who had built up a track record in the long bull market of 2003-2008 are now in serious trouble. The sustained bull market rewarded risky behaviour. Now, this has changed dramatically. Risky behaviour is being punished with severe volatility, and volatility is something the star rating methodology penalises heavily.

But investors do not need to change their attitudes dramatically. The new environment does need more frequent evaluation of your investment choices. Once upon a time you could have chosen a good fund and just forgotten about it.

From now on, you'll need to take a close look perhaps once every few months. However, taking a close look doesn't automatically mean buying or selling. If a fund drops one star, it isn't the end of the world. Many good funds go one star down and up quite frequently. Moreover, the star ratings are not intended to be the dominant way of evaluating funds. They are a starting point and their biggest utility is as often in eliminating the bad choices as in highlighting the good ones. If you've chosen funds whose basic objective suits your needs and it's anywhere in a high rating, you'll be fine.