Jun 30, 2017 3 min read

Does Mutual Fund Star Ratings Assure Better Returns?

Not all five-stars rated schemes will perform great in the market, the one with a single star can be more beneficial to you. Know how.
The trend of increasing mutual fund investment is climbing the heights because of awareness among people to - ‘earn more, save more.’ Many new investors are entering into the world of mutual fund investments through various sources, while the old ones are making their investment portfolio stronger by pouring additional schemes into it.

But, most of them face losses because of one common mistake of choosing the funds based only on the star ratings. Yes, you read this correct! The mutual fund’s star ratings are not meant to assure good performance of the schemes, rather, they measure their risk-adjusted returns over different time frames like three-year, five-year, etc.

What Does Mutual Fund Star Ratings Reveal?

The rating agencies like CRISIL, IRCA, Value Research, etc., arrive at the results after considering a long-term past performance of the scheme, fund manager’s skills, and consistency in returns. The mutual funds are rated to showcase their historic run in various market situations to the investors and never ensure superior returns. This is because the past performance is not guaranteed to be replicated in the future.

Should You Rely on Star Ratings?

There is no doubt that the ratings provide a bird’s eye view of the fund’s performance and many investment advisors use them as a reference toward building their client’s portfolio. However, you should not solely rely on these stars because the best-rated scheme may fail to make an identical run in the future.

For instance, when we go to a pharmacy, we don’t ask them to give us the best medicines. Rather, we buy the one as per our requirements. Similarly, you should not keep adding the best-rated funds in your portfolio, but, buy the ones which suit your investment objective and risk profile.

Limitations of Mutual Fund Star Ratings:

Mutual fund star ratings have certain limitations which are:

  • Backward-Looking : It is very crucial to know the consequences of both side of a coin. Mutual fund ratings tell only the one-sided story which may be harmful to the growth potential of the entire portfolio. The ratings are based on the analysis of historic attributes which cannot assure the future movements.
  • Unstable Ratings : The rating agencies assign certain weights and parameters based on which they rate various funds. A slight change in the weights or other factors can make a bull difference in the ranking. Hence, this volatile nature of the grades can be riskier for you to be dependent on them.
  • One Size Doesn’t Fit All : Mutual fund ranks are based on different time periods, and should not be perceived as buy/sell recommendations. For instance, your investment objective may not be the same to that of your friend, or you may be a risk-seeker while your friend is a risk-coward. So, it is not necessary that a four or five-star rated scheme will suit all kinds of investors.

How to Use Mutual Fund Star Ratings?

We have already discussed above that mutual fund ratings suffer from various limitations; they can be beneficial too while choosing a good scheme if used wisely. There are a few simple steps following which you can select the best mutual funds to match your portfolio. They are:

  1. First of all, take all the best-performing schemes into consideration. You can count the one which has been rated more than three stars by any recognised rating agency, or you can also select the same on the basis of your own analysis of past performance of the scheme (if you are a well-informed investor).
  2. You can scan the selected schemes to find those matching your investment objective and various other attributes like risk profile, investment style, tenure, etc.
  3. Once you are done with the collection of all the best-performed schemes as per your requirement, you should further filter your search by analysing the ability and stability of their fund houses.

Thus, you can rely on the mutual fund ratings to a certain extent but not entirely. To select the best suitable scheme as per the investment needs, one must go through the simple process of analysis or take experts’ advice.

This is said that mutual fund star ratings cannot assure the future performance of the scheme. But, a mere prediction can be made that how the fund will move in certain market situations which might be helpful. To check the rankings of various schemes, you can browse our online investment platform, i.e., MySIPonline.