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Can a top-rated mutual fund perform badly?

If you had invested in a top notch fund based on such rating methodology, can you expect it to perform poorly in the future?

Analysing mutual funds, for most investors, often means looking at NAV performance and star ratings. Many independent agencies assign ratings to funds to make the choice-making easier. 

How do the ratings work?

Here, the performance of funds belonging to a certain category (say large cap equity or ultra short term debt) is analyzed against their peers using a quantitative measure (risk-adjusted returns). And subsequently, they are assigned ratings on a relative basis – for instance, top 10% of funds are awarded five stars, the next 22.5% receive four stars and so on. 

Now, if you had invested in a top-notch fund based on such rating methodology, can you expect it to perform poorly in the future?  

Before we delve on it, you need to understand the following:

1. Past is history

All the ratings are based on the past performance of funds and there is no guarantee that it will continue to do well in the future too. In the US, a 10-year study of the fund ratings found that over the period 2004-2014, only 14% of five-star funds continued with their highest ratings. And if an investor was willing to accept a four or five-star performance, the results were more palatable, About 51% of five-star rated funds in 2004 received a four-star or above rating in 2014.

It shows ratings might not be a good predictor of fund performance. However, if you are staying invested for the long-term without chasing highest return givers, then you stand a better chance of owning an outperformer. 

2. How long have you been invested?

Moreover, the growth you earn depends a lot on your investing behaviour. Past surveys have indicated that investors earn lesser returns than their funds primarily due to two reasons. One, they try to time the market. Two, they constantly hop-out of underperforming funds and hop-into top-performing ones without realizing that they might have perhaps lost out on much of the gains. 

It is impractical to assume that a fund will do well at all points in time. There are phases when it will underperform or outperform based on its portfolio orientation and market trends. So figure out, for how long you are invested in the fund? 

It is important to evaluate the consistency of a fund’s performance that is better captured in the longer horizon of 7-10 years. 

3. Are you diversifying?

Diversification improves the odds of your portfolio to outperform the market. By prudently choosing three to four funds in your portfolio that are complementary in nature, you could aim to build a portfolio that not only provides downside protection but also better performance. Such diversification strategy will lessen the urge to switch schemes frequently.

4. Which ratings do you follow?

Many independent rating agencies provide mutual fund ratings. While most use a risk-adjusted return methodology, they differ in the time horizon they consider. Some take long-term performance as basis, while others have a recency bias. 

It is important to evaluate the consistency of a fund’s performance that is better captured in the longer horizon of 7-10 years. 

5. Is there an investment process?

When a fund underperforms, investors think it will not bounce back and exit it. However, the correct approach would be to check if the fund manager follows an investment process. There are two types of investment process – one which is the normal regulatory process while the second has to do with the managerial approach including measures to protect portfolio and choose stocks or bonds. 

A good financial advisor will be able to tell if the fund is following a proper process of investing. 

Often investors mistake underperformance as a fund manager losing their edge. However, once the market starts favouring a particular style of investing (that they exited), they are caught on the wrong foot. 

Takeaway

First of all, get the asset allocation right.  Stay invested for a time period of at least five years if investing in equities and exit funds only when they consistently underperform. Even here, you need to check if the recent underperformance has got to do with the market favouring a particular style of investing or otherwise. 

Mutual fund ratings are not predictive. So, top-rated funds could perform poorly in the future. Keep tabs but understand the long term view.

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