Are mutual fund ratings’ dependence on past data to predict the future a flaw in itself? Most likely, yes. These ratings, which judge and rank schemes, rely on bygone performance. These give no guarantee of outperformance in the future, but most of the flow into the mutual funds goes to schemes that have the top two ratings. Experts say this promotes an unhealthy practice of churning and performance chasing, where investors sell low and buy high.
Only last month, an American investment scholar said the rating system merely identified funds that performed well in the past; it provided no help in finding future winners. “Nevertheless, investors respond to industry come-ons and load up on the most ‘stellar’ offerings,” David F Swensen of Yale University wrote in New York Times.
Now, a study by Business Standard shows top-rated funds in the 5-star and 4-star category received a lion’s share of inflows. In 2008, these funds received 95 per cent of inflows. In 2009, these funds received inflows, while the lower-rated funds saw outflows. Similar trends were repeated in subsequent years, too.
| NOT A RELIABLE POINTER Rating-wise total flows (Rs crore) | ||||
| Star rating | 2008 | 2009 | 2010 | 2011 |
| 1 | 17.91 | -14.43 | -27.21 | 12.62 |
| 2 | -129.19 | -1,097.84 | -598.32 | -71.01 |
| 3 | 270.51 | -189.29 | 837.49 | 1,467.81 |
| 4 | 1,880.96 | 2,725.94 | 2,994.68 | 2,911.88 |
| 5 | 1,558.07 | 1,533.25 | 1,047.36 | 1,041.32 |
| What the ratings show | ||||
| * Past returns | ||||
| * Consistency of performance | ||||
| * Performance under different markets | ||||
| * Portfolio quality | ||||
| What they don’t | ||||
| * New funds and themes | ||||
| * Future market trajectory | ||||
| * Future decisions of fund managers | ||||
| * Change in fund manager | ||||
| * Impact of inflows/outflows | ||||
Last year, the lower rated funds saw outflows of Rs 615 crore, while the top rated categories saw inflows of Rs 4,041 crore. In the first six months of 2011, top-rated funds received inflows of Rs 3,952 crore, while the bottom two categories combined saw an outflow of Rs 58 crore.
Since there is no direct data available on the amount of funds the respective star rated funds received, the BS research bureau has calculated these from incremental units in each scheme and multiplied these by the average net asset value to calculate the annual fund flow. A number of agencies in India provide ratings of mutual funds based on their past performance. US-based Morning Star, Icra, IFast and Valueresearch are some of the most used MF ratings.
Fund companies, advisors and agents use these ratings and awards, which are based on past performance of the scheme to advertise and market these products to customers. But going blindly by the ratings can be misleading, say experts. Swensen, in his Oped-page article, said the ratings encourage unnecessary churning from lower-rated funds to the higher-rated ones thereby making the investor sell high and buy low.
“This churning of investor portfolios hurts investor returns,” he wrote. “First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.”
Rajesh Krishnamoorthy, CEO, iFast Financial Services, says there is a theoretical possibility that flows to the top rated funds are higher, but these need not necessarily be from redemption in lower rated funds. “Any parameter that will predict the future accurately can be better than the present rating system...unfortunately, there is none. Since we don’t have a proper system, we are managing with what we have, which could be as good as having none.”
Karthik Srinivasan, co-head (financial services), Icra, which rates funds up to seven stars and confers awards for every category annually, says his firm, like the others, look at funds for a consistent track record. “It is an educated call. Based on the track record, there is a likelihood that these funds will do well in the future. But subsequently, if they change their view, there is a problem.”
Experts also point out that ratings typically do not take into account changes in market conditions and fund managers. Some analysts also say the inflow of more funds itself leads to several evils. First, the performance is likely to get affected, as it may not be able to deploy the larger size with the same efficiency when it was smaller.
Second, a successful fund continuing to attract inflows can prevent newer ideas from hitting the market. “One fundamental issue with ratings,” says Krishnamoorthy, “is that it tends to ignore new themes and new products, even though they are promising.” The methodology is “highly driven by statistics and an inclination to a minimum of 36 data points. This automatically lets out funds that are less than three year old”, he adds.
While investors need to look at star ratings as an additional tool in their decision making and not a conclusive one, advisors and funds also need to make proper disclosures.
Devendra Nevgi, founder and principal partner, Delta Global, says funds and advisors who use these ratings for selling need to give clear disclosure on the methodology and a disclaimer that they cannot in anyway guarantee future performance. “A five-star rated fund is not necessarily the top performer in the market. Rating should not be the only deciding factor. It can be a tipping point, if an investor is happy with other features of the fund.”
