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Cricket and fund ratings

What do the Value Research fund ratings have to do with cricket's Decision Review System?

Cricket and fund ratings

Are you a cricket fan? Are you a cricket fan of an age when you started following cricket before the Decision Review System (DRS) was introduced? For the longest time, any number of older fans were making a humans vs machines argument while opposing DRS. They mourned the fact that instead of umpires having the final say, as they have had since the beginning of the game, machines were now supreme. An algorithm could overrule the umpire.

I'm not much of a cricket fan so I don't have a view on this particular aspect of the game. However, I do note that the terms of the debate themselves are misstated. It's not a humans vs machines thing at all. Instead, it's about humans being helped by machines. When the decision is difficult, the human's capability is enhanced by that of the machine. The net result is an improvement, not a competition. There is only one side to this story, not two.

There's an aspect of mutual fund investing that's exactly like this. Over the last month, as the long awaited Value Research Premium has launched, a lot of people are asking me an analogous question and I'm finding it quite interesting thinking through the whole issue, specially because Value Research Premium is just one example of the underlying discussion. This actually applies to many, many investment analysis systems, for stocks, mutual funds or indeed for any other asset type too.

At Value Research we have long had a monthly rating system for mutual funds. It's freely available on our website and is also published in our Mutual Fund Insight magazine. The system is close to three decades old and while it has continuously evolved along with changes in the mutual fund environment and investor needs, it remains a purely algorithmic system. Every month, our data team pours in the numbers into the ratings machine in our office and the ratings come out of the other end. Then we package the ratings and ship them in trucks to investors all over the country.

You may feel that the actual process is a little different than what I'm describing but I assure you, the principle is the same. The important thing is that no one fiddles with the machine on a fund-by-fund basis. The machine does the exact same thing to every fund of a category. And just as importantly, the inputs that go into the machine are all publicly available data. No one modifies the data before it's put in.
However, in Value Research Premium, we also have a qualitative process wherein I and our analyst team apply our judgement and experience and select some funds as specially desirable for investors. We also map these to actual investor needs. This is different from the mechanical rating system which is more closely based on SEBI's official mutual fund categorisation guidelines.

This is the DRS-vs-umpires dichotomy that some of our members get thoughtful about. Even if you don't use Value Research services, this dichotomy is there in any investment evaluation system . The spreadsheet says something but the judgement of an experienced investor sometimes disagrees. In our case too, some of the ones that are rated five star by us do not find a place in our list of investment-worthy funds.

The mechanical ratings system is a great starting point. You or I can't evaluate everything ourselves so we need something that does the basic job for us. Sometimes, judgement has to be used to overrule the system. The important thing is that the two should not be mixed. They play different roles and each must remain distinct.

There's one more thing that I have seen over these decades that also applies to any mechanical system. Such systems have a higher utility in a negative sense than in a positive sense. If the system rates something poorly (I mean poorly, not middling) then that investment should always be avoided. In general, making an effort to avoid bad investments is a key part of investing but something that investors tend to ignore because it's not as exciting as hunting for the good stuff. Mechanical systems do this mechanical job very well.