Star Ratings – How to use them

Choosing a fund is not just science but also an art. If it was science, then by simply investing in top rated funds would have sufficed the need.

So lets see how one choose a fund and how ratings help in the process.

  • First choose the asset allocation between equity and debt
  • Then within equity whether largecap, midcap, multicap, smallcap, sector or a hybrid fund basis your risk and time horizon
  • Say you select largecap.. Within largecap select funds that have consistent performance (here star ratings can help, but they will only tell you recent performance as most ratings have higher weightage to recent performance)
  • To avoid recency bias overlap this by a quick deep dive. See for yoy returns for maximum period possible, at least 10 years if available, and how the fund has performed during good times and bad times compared to its benchmark
  • See for fund manager changes. If the FM is changed recently then ratings and any past performance analysis will have limited scope to give you any colour on the fund. Avoid such fund and wait for some time.
  • Study the portfolio of the fund. Look for sectors it is invested currently and check it against the benchmark, see if fund manager taking skewed sectoral bets compared to benchmark. Higher sectoral skeweness may have more cyclical performance – be ready for it.
  • Sizing your allocation across chosen funds is the most important step. Equal weights is the basic way, unless you have wherewithal to analyse future performance and consistency.

Important to note is ratings will help you just filter current good performing funds, I repeat, current good performing. If funds start doing bad agency will not hesitate to rate it down to 3 from 5. Does it means that you now need to sell that fund? No! There are instances when a fund has seen ratings travel from 5 to 2 and back to 5. Stay put and some of the steps above may help you analyse whats wrong.

Happy Investing!

Secret: Sundaram smallcap fund was a 5 star rated fund just couple of years ago. It is now 2 star. What will happen to investor who invested when it was 5 star? Think about it before you invest in a fund ONLY because its 5 star rated.

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