Many people choose the fund in which to invest by looking at the rankings / ratings. I have always held the view that ratings are backward looking and so it does not serve as serious tools for choosing a fund in which to invest.
It took some long conversations with some serious knowledgeable investors to understand what they did not understand! So here is an attempt :
- Peer benchmarking is of no use for thematic funds: OMG this sounds like Greek? Hmm.. well if I run a Value fund I promise to deliver value over a long period of time – say 5-8 years. However the rating business happens on a far more regular basis (say monthly, i will not be surprised if they start doing it weekly – the software allows me to do that, you know? ). So on a week to week basis if you are going to compare my fund to some other fund, please do not invest in my fund. Examples of this are Templeton India Growth fund and Prudential India Discovery Fund. Over long periods of time they have delivered good value, but I do not know whether they have week on week or hour on hour remained a 5* fund.
- A 5* fund means nothing! If I decide to club a few genres of funds, I will have say 200 ‘equity funds’. Now to be in the 5* category I need to be in the top 20 that is all. And as and when I keep adding to this big set, it becomes more and more easy to retain my 5* ranking.
- Generally all funds immaterial of age and size are compared: Yes they do have a 2 or 3 year cut off so the very young funds do not fit into it, but still this is broadly true.
- We keep reading again and again that the past is not a good indicator of the future, but still feel happy when we invest in a fund which is in the 5* category, hoping that it remains there forever the 20 years that we will stay invested. This is really funny.
- If I create a fine enough sub group I can make sure that there are only 5 funds in one category: thus ensuring that the 5* category has only one player, permanently. Sounds mischievous? Not unthinkable, right?
- Exactly the opposite of e is also true.
- The rating agency is a very big beneficiary of the rating – the fund industry will happily use the rating and advertise it. Who benefits by the advertisement? the rating agency! Lol. This was so visible to us in the car industry a few years earlier – currently too many people rating cars, and too few people rating mutual funds. Sigh, alas.
- The gap between the best fund and the second best is not even worth the effort taken to measure it!