Over the last few weeks, I have had some queries from readers about the problems faced by mutual funds that have had good ratings from Value Research. This issue is not new. Since the launch of ratings three decades ago, there have been many occasions when we have been asked by readers why highly rated funds have done poorly. In case of debt funds, there have been occasions when highly rated funds have run into credit quality or liquidity issues, as some have done recently.
My response is simple and has always been the same. It's important to understand what the rating system is, how it serves you and what you can and cannot use it for. The 'cannot' part in the previous sentence is probably the most important.
Firstly, the rating is a purely arithmetic, data-driven exercise in which all funds are treated by the same algorithm. Any opinions or subjective judgement of mine or anyone else in Value Research plays no role in the ratings. It goes without saying that since the data is all from the past (we can't see into the future!), the ratings are an evaluation of how funds have done in the past. Generally speaking, the past is a reasonable guide to the future but sometimes it is not - this lies at the heart of all methods of investment research, no matter what type of investing we are talking about.
Secondly, funds are rated not on how good they have been, but on how good they have been in comparison to other funds of the same category. This relativity of fund ratings has an important implication. Hypothetically, if every fund in a category is lousy, then the least lousy among them would get a five-star rating. The opposite is also true. If all funds were wonderful, the least wonderful would still get a one star. Of course, this doesn't actually happen. In reality, there are always great funds and there are lousy funds and a whole range between them.
Moreover - and this is of the utmost importance - if a category is unsuitable for you, then it does not matter which funds have four or five stars. They are all unsuitable for you. This has been a big problem in recent times. People who should have invested in equity hybrid funds chose small-cap funds and those who should have chosen liquid or overnight debt funds chose credit risk funds.
So how should you use the ratings? The starting point for any fund-investment process is to choose the right type of fund. After that, the next best step to use the ratings is to use them as a negative filter. Generally speaking, the one or two star funds can be eliminated from further consideration. Only after that does the rest of the process start, which involves a careful valuation of each fund from a variety of objective and subjective parameters. Do I expect each and every fund investor to do that? Are all of them going to go through this process?
Definitely not! And this is the reason that we have, over the years, launched products like the Mutual Fund Yearbook, which has evolved into Best Funds for Growth, Income and Short-term Goals, and 'Value 50', which has evolved into 'Fund Analysts' Choice'. Instead of the technical categories, these take actual investor goals and give a small (the 'small' is very important) set of funds that satisfy those goals. Whereas a category may have a 100 or more funds, these goals have barely a handful.
Let the ratings be a professional and technical tool for research. Individual investors should be focused on the goal-oriented recommendations that we produce.