November 29, 2014

How should Star Ratings be used?

Given the extent to which financial advisors and investors refer to the Star Ratings of mutual funds (particularly, those by Value Research), I find that there is surprisingly little awareness of how these ratings are derived, or what these really signify.  In fact, in all the years that I have discussed this topic with advisors and investors, I cannot remember meeting anyone who knew the methodology behind these ratings.  I find this particularly worrying because the perceptions that most advisors and investors seem to have regarding these ratings are deeply flawed and the clarity needed can easily be gathered.  Value Research prominently displays links to an explanation of its methodology and an FAQ on the home page of its website. 

While I encourage readers to check those out, in this post, I offer my thoughts on how to use, and how not to use the ratings.  Important: What I have given below will make most sense only after you have familiarized yourself with the methodology and have seen the FAQ.  Also, do note that my thoughts on using these ratings somewhat differ from what Value Research suggests in the FAQ.

Like Value Research, I recommend using Star Ratings as  a quick way of comparing the past performance of similar funds.  However, if the intention is to select a fund to invest into, I strongly suggest not using the Star Ratings as the primary basis for doing so.  In my understanding, the primary basis for selecting a fund should be the qualitative aspects such as the quality of the fund management team, their investment process, and the investment philosophy behind each fund.  Once you build a shortlist of funds using these parameters, Star Ratings can be used to further refine that list. 

Fair Comparison
The Star Rating of a fund is based upon its performance relative to other funds in the same category.  Hence, before comparing the Star Ratings of two funds, it would make sense to be sure that these funds are in the same category, as defined by Value Research.  In the case of equity funds or hybrid funds, I would go a step further and divide the funds in each category into two sub-groups: a. those that have been around for 5 years or more, and b. those that have been around for less than 5 years.  This is because the data used to determine a fund’s Star Rating is different for these two categories of funds.  In other words, before comparing the Star Ratings of two funds, I would want to be sure that these are in the same category as well as the same sub-group.

Bear in mind…
  1. Funds with adjacent Star Ratings (e.g. 5 star and 4 star funds, or 4 star and 3 star funds etc.) can often have negligible differences in performance.
  2. Star Ratings are just one way to compare the past performance of similar funds and shouldn’t be regarded as the only way or the best way to do so. 
  3. Star Ratings, like most standardized tools of analysis of past performance, do not capture the role of luck in the performance of a fund.
Next ➡ ⬅ Previous