Oct 27, 2017 4 min read

Should I Invest in a Five-Star Rated Mutual Fund?

Is investing in a mutual fund just by observing its five-star rating a wise decision? Find out here!
Mostly all the uninformed investors ask this question from us. So, we are back to help you understand the real meaning of mutual fund star rating, and also how effective it is to invest in five-star rated schemes.

Let’s take the example of bike racing to explain this scenario! As it is not crucial that only if you have an excellently modified bike, then you will win the race. It majorly depends on the rider that how efficiently he rides the bike and reaches the finish line. Similarly, the performance of the mutual fund investments also majorly depends on the ability of the manager of the scheme and not solely on the star ratings. A high rated fund only shows that how it has performed in its past and do not make any anticipation of its future performances. Therefore, investing in a fund just because it is holding a five-star rating may not be a wise decision. With the help of this blog, we want to alert you from making any such mistake in your investment. But before that, let’s take a glance at what is mutual fund star ratings and how they work!

What Is Mutual Fund Star Ratings?

There are companies which are known as rating agencies. They study various pros and cons of the mutual funds from their past performances over a certain period of time, and based on those performances these rating companies rate the various schemes. The rating ranges from one to five stars of which one star denotes the lowest performer whereas the five-star rating is for the best performer. There are various entities which are actively working on this job such as CRISIL, Morningstar, Value Research, ICRA, etc. All these companies have different philosophies of rating the various mutual funds.

You might be thinking that when these rating companies are providing the stars to the various schemes on the basis of their performance, then how the top-rated funds can be a wrong choice for anyone. Yes, you are correct to some extent, but possibly you might not have considered the word “Past” performance. It is said that the star ratings entirely depends on the past performance of the schemes. And, it is known to all that no one can guarantee future returns as it depends on the future market situations. So, the rating agencies never assure that the scheme which is rated five-stars today will perform similarly in the future too.

Therefore, one should not simply invest in any scheme considering only its rating. You must know the various limitations of star ratings before choosing a five-star rated fund.

Limitations of Mutual Fund Star Ratings

Limitations of Mutual Fund Star Ratings

Past Performance: In mutual fund investment, it is very important to consider all the aspects, i.e., past performance of the scheme as well as the future potential to generate returns. But, the star rating offers only the knowledge of the past performance of a fund and do not depict any hint for the future returns potentiality. Therefore, one should not entirely depend on the five-star rated mutual fund.

Objective Based: The rating agencies works on certain factors which they keep same for almost all the schemes to rate them. They keep doing their research and studies on the fixed factors which has already designed by the company. But, if we see the scenario on the part of investors, online mutual fund investments are based on both subjective and objective factors. There are different requirements of different investors who might have varying investment styles. Therefore, the research based on certain fixed factors cannot match up with the requirements of every investor.

Unstable Ratings: The rating agencies use certain parameters to rate the schemes. These parameters are assigned weights based on some factors of the performance of the scheme. Therefore, a little change in the factors or the weights can bring changes in the ratings of the scheme. Thus, a four-star rated fund may fall to two-star. Similarly, a one-star holder may suddenly jump to five-star.

Therefore, it is not always reliable to believe the star ratings of the mutual funds. It is better to invest in the funds matching the other investment details such as risk appetite, style, fund manager’s capability, objectives, expense ratio, past performance, etc. If you are confused between the schemes of similar nature and want to compare the both to know the best option for investment, then we, at MySIPonline, have ‘Compare & Invest’ feature using which you can make a comparison between schemes and opt for the most suitable one as per your requirements. We have excellent facilities for our clients and are providing simplified online investment solutions.