Can I pick up top rated funds from Crisil or Value research and invest in them? How reliable are Crisil Ratings or Morningstar ratings? I invested in top rated Crisil fund last year now the fund rating has changed should I switch? 

These are some of the popular questions that investors keep on asking on various investing platforms. Essentially, all of these questions can be rephrased into the following simple question:

Are Mutual fund Ratings best way to pick up a mutual fund?

The short answer to the question is No. To select a mutual fund, there are a variety of parameters to be kept in mind.

Let us analyse these in detail:

1. Different rating agencies can rate funds differently:

We picked up an example of top mid cap and small cap funds and tried to look at how they are rated across different rating agencies results are below.

Let’ say, if you pick up UTI Midcap fund because Value Research rates it 5 Star and then tomorrow when you go to Crisil site, you would realise that it is rated 3. So, what to do know and which one to trust. Well, in reality, both these ratings are completely fine, the variation comes from some differences in their methodologies.

2. Ratings can change within a year:

Next thing, we looked at is, how do ratings change from year to year for some funds. Here, we took an example of the top 3 Midcap/small cap funds . If you look at the table below, a fund which was top in 2014 was not top fund in 2015. So, if you are investing for the long term,Will you be shifting funds every year? This also means ratings have a limited predictive value while they are reasonably good at analysing past performance their predictive value is not up to the mark. Mutual funds ratings have very little predictive value.

3. Ratings may miss certain factors:

Ratings usually consider all the important factors for mutual fund selection. But, they might not take into account adequately factors like expense ratio, profile of the fund manager and other macroeconomic indicators that can impact fund’s performance in the coming times.

How do we select right Mutual Fund to invest?

So, what are we missing what is the way forward? To start with, we need to rephrase the question we asked initially. When you select a mutual fund to invest, you are not buying into the rating. What you are doing is choosing a fund which fits into your investment goals. So, starting point should not be a Mutual fund rating. To select mutual fund, we should start with a clear investment goal.

Here are broad steps you should follow while selecting a mutual fund:

1. Articulate your investment goal.
2. Set up your return expectations.
3. Use ratings to shortlist funds which qualify the criteria you have set up.
4. Look for consistent performances over long periods because mutual fund investments are to be done for a longer haul. So, it is prudent to see if a fund has performed consistently over the long run.

Mutual Funds Selection: Summary of our discussion

• Rating agencies are good indicators but they may have certain limitations in predicting future performance.
• Ratings should be used primarily to shortlist mutual funds and not to choose mutual funds.
• A good mutual fund selection should synchronise with your requirements with great consistent performance over long time periods.
• Finally, you must be able to build a strong investment portfolio meeting your overall financial objectives.

Disclaimer: This post is not a financial advice. Mutual funds are subject to market risk. Please follow due diligence and be cautious while investing your money in any of the risky asset classes or consult your financial adviser before taking an investment decision. Fintrakk.com or any of its representatives are not responsible for any loss that might happen due to your investments.