Ranking and rating of schemes

Mutual fund research agencies do not just publish raw returns. Many of them process those returns further, into a rank — first, second, third within a category — or into a rating, grouping schemes with similar performance traits into bands, often shown as stars.

A five-star scheme reads as better than a four-star one. That comparison is fair as far as it goes — but it describes only the past. Almost every rating the workbook discusses is an assessment of what already happened, with no claimed ability to forecast what happens next.

Chapter 12, Box 12.1, sets out three things an investor has to understand before acting on a ranking or rating:

• Methodology varies by agency. Each research house has its own distinctive method, published on its own website, and a "5-star" from one agency is not built the same way as a "5-star" from another.
• A rating is a look backward, not a forecast. Almost every published rating measures past performance and carries no predictive ability for future performance, however the marketing around it reads.
• Rankings churn. Quarterly performance data shows that the top-ranked fund in one category one quarter is not necessarily the top-ranked fund the next quarter — chasing the current leader every quarter is neither realistic nor advisable, and switching schemes that often brings its own costs.

The workbook's practical suggestion: aim to stay invested in schemes that are consistently among the top few in their category — roughly the top 3 to 5 where a category has few schemes, or the top 10 to 15 percent where it has many — rather than chasing whichever scheme currently sits at number one.

A research agency rates a large-cap equity scheme 5 stars based on its trailing 3-year and 5-year risk-adjusted returns relative to its category peers.

An investor sees the 5-star badge and switches Rs 8,00,000 out of a 3-star scheme into it, expecting the outperformance to continue. Two quarters later, the newly 5-star scheme has slipped to 3 stars, while the scheme the investor left has climbed to 4 stars — exactly the quarter-to-quarter churn the workbook warns is common.

Had the investor instead looked for a scheme that stayed consistently in the top few of its category across several quarters — rather than chasing whichever fund topped the most recent ranking — the switching costs, and the risk of buying in just as a scheme's run of good luck ends, would both have been smaller.

Chapter 12 (Mutual Fund Scheme Selection), section 12.3, introduces ranking and rating as tools built on the risk, return and risk-adjusted-return parameters covered earlier in the chapter, and Box 12.1 details the caveats. Expect a question on whether a high star rating predicts future performance — it does not — and on the "top few, consistently" guidance as against chasing the single best performer each quarter.

• A rating reflects the past. It is not, in the workbook's own words, "indicative of the future performance of the scheme" in almost every case.
• Different agencies use different methodologies — a rating is only comparable to another rating from the same agency, using the same method.
• Chasing the top-ranked fund every quarter is explicitly discouraged, both because rankings churn and because switching has its own costs.
• "Top few, consistently" is the workbook's own recommended approach — not "top one, right now."