Is It Right to Buy Mutual Funds Based on Ratings?
A fund may earn a five-star rating because of its great performance over the last six months or because of bold, high-risk stock bets that paid off very well. It is essential to remember that past performance and ratings are not assurances of future success.
Ratings can be useful, but they should not be the only basis for your investment decisions. Always consider the long-term strategy of the fund, its risk profile, and how it merges with your financial goals before investing.
For example, a 48-year-old investor X wants to invest in an equity mutual fund for retirement. Overwhelmed by hundreds of options that all seem to be the same. The investor, who lacks expertise in the assessment of funds based on risk, asset allocation, or strategy, is attracted to five-star ratings. Now the investor (X) questions whether choosing a top-rated fund is the best approach or not?
X needs to decide whether a five-star-rated fund ensures steady performance at its best. Then the answer is no. This is usually not true. If the five-star fund were the best, then all the rating agencies would have recommended it. There are large differences in the ranking of mutual funds. All financial advisers and rating agencies cannot suggest the same funds as the best or give five-star ratings to them.
Each rating agency uses a different methodology to evaluate funds. A fund can achieve a five-star rating because it has done remarkably well over the past six months or because it has made high-risk stock bets that resulted in significant returns. The performance of the mutual fund can be more unstable. A fund’s five-star rating does not ensure its future outperformance.
Ratings are often revised and can fluctuate with time. Therefore, X needs to select a fund with a better track record, allowing X to assess its performance consistency over time. X needs to examine the rating methodology to understand the place of consistent performance and return relative to the level of risk taken.
Therefore, X should select a fund with a solid track record, allowing her to assess its performance consistency over time. X should also examine the rating methodology to understand the emphasis placed on consistent performance and returns relative to the level of risk taken.
Star ratings may be a good starting point to shortlist mutual fund schemes, but they should not be the sole basis for your decision. Investors need to evaluate the rationale behind these ratings, consult a financial advisor, and understand the strategy of the fund. This will allow investments to be aligned with individual risk-return preferences rather than reliance on star ratings.
