How to Use Star Ratings to Choose the Right Mutual Fund?

Mutual funds come in all shapes and sizes, and for most investors, picking the right one can be confusing. This is where star ratings come in. But what is star rating in mutual funds, and should you trust it blindly? Let’s break it down simply and clearly so you can make informed investment decisions.

Understanding Star Ratings

Star ratings are a quick way to judge the past performance and risk level of mutual fund schemes. Just like a five-star hotel rating gives you an idea of quality, a fund’s star ratings act as a summary of a fund’s historical track record. These ratings are not decided by fund companies themselves, but by independent agencies that use data-driven criteria.

They help investors compare mutual fund schemes at a glance and narrow down options before digging deeper. But while they seem convenient, understanding how they are calculated and what they represent is essential.

Who Determines the Star Ratings?

Star ratings are typically assigned by independent rating agencies like Morningstar, Value Research, and CRISIL in India or their counterparts globally. These agencies assess funds based on performance metrics, expense ratios, volatility, and risk-adjusted returns.

It’s important to note that different agencies may use slightly different methods and time frames. This means a fund may have a 4-star rating from one agency and a 3-star rating from another, depending on their internal methodology.

These rating agencies aim to offer unbiased insights to help both retail and institutional investors.

What Factors Influence Mutual Fund Star Ratings?

Star ratings are generally based on a fund’s past performance adjusted for the level of risk taken. This is known as a risk-adjusted return. For instance, if two equity funds gave the same returns over five years, the one that achieved those returns with less volatility or risk might get a higher rating.

Some of the common metrics used to calculate fund star ratings include:

• Sharpe Ratio: Measures risk-adjusted performance.
• Alpha: Indicates a fund’s excess return over a benchmark.
• Standard Deviation: Shows how volatile the fund has been.
• Expense Ratio: Affects net returns.

Time periods considered are usually 3, 5, and 10 years. This helps the rating system avoid short-term biases.

Breaking Down the Star Rating Scale

Most rating agencies use a 1 to 5-star scale, where:

• 5 Stars: Top 10% of funds in their category based on risk-adjusted returns.
• 4 Stars: Next 22.5% of funds.
• 3 Stars: Middle 35%.
• 2 Stars: Next 22.5%.
• 1 Star: Bottom 10%.

So, a 5-star rated mutual fund doesn’t necessarily mean it will continue to perform well; it simply means it has performed better historically than 90% of its peers.

This scale allows investors to compare mutual funds within the same category, such as equity funds or debt funds, more fairly.

Benefits and Drawbacks of Star Ratings

Benefits:

• Quick Comparison: Helps investors screen rated mutual funds easily.
• Risk Awareness: Highlights the level of risk involved with different funds.
• Objective Analysis: Based on data, not marketing or branding.

Drawbacks:

• Past ≠ Future: A high rating doesn’t guarantee future performance.
• Category-Based: You can’t compare an equity fund’s 5-star rating to a debt fund’s 5-star rating.
• Changes Over Time: Ratings are dynamic and may change due to market movements.

It’s always best to use star ratings as just one of many tools in your decision-making process.

Conclusion

To sum it up, what is star rating in mutual funds? It’s a simple scoring system designed to help investors judge a fund’s past performance relative to risk. While it offers a handy snapshot, it’s not the whole picture.

Make sure to look beyond just the stars, understand the fund manager’s style, check the expense ratio, and see if the fund aligns with your financial goals. Ratings can point you in the right direction, but your own research will guide you home.

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