Investing In Mutual Funds: Check Out The Ratings

Investing in Mutual Funds: Check out the ratings

Obtaining reliable information is the essence of any sound investment strategy. With the growing popularity of mutual fund investing, consumers need a reliable source to help them track and evaluate the performance of their mutual fund holdings, more so in current context when investors are faced with surfeit of products across the board suited to all sizes with different risk-return characteristics. Moreover, with the more transparency, advertisements, fund coverage’s, experts advises etc. gaining traction, a retail investor is left bemused about his idealchoice of mutual fund and often lands up picking up a wrong product.

Credit Ratings: An important tool

A handy indication toward investing in mutual funds is emerging fast in mutual funds with good ratings. “Credit rating is an opinion expressed by an independent professional organization, after making a detailed study of risk-return parameters including past performance, Industry exposure, management track record, assets size, portfolio concentration, peer comparison analysis etc.” Such an opinion or rating is gaining wide recognition amongst investors as they can take informed investment decision by examining the fund risk vis-à-vis their risk appetiteand to certain degree can rely on the credibility of the Credit Rating agency. Fund managers would use such ratings for communicating their target level of credit risk of their schemes to investors. For issuer, a good credit rating enables them win investor confidence. Also, in some cases there is a compulsion from the regulators to have credit rating assigned to certain debt issues.

Credit Ratings: Various methodology & ratings

There are several creditratingsagencies in India providing services to mutual fund industry. At present there are 4 renowned credit rating agencies including CARE, CRISIL, ICRA, FITCH India and Brickworks India, registered with RBI. (Source: RBI). Rating Methodology from aforesaid agencies is broadly based upon evaluating the inherent quality of the mutual fund’s portfolio. The performance criteria covers not only risk adjusted returns, which are historical, but also the portfolio characteristics like industry/company concentration, liquidity etc. to make the analysis forward looking. Let’s understand their individual methodologies briefly:

Typical Parameters considered by Credit Rating Agencies

•Industry Risk Exosure

•Fund House Market Positioning

•Evaluation of Credit Quality of Individyal Assets

•Past Fund House Performance Analysis

•Management Quality

•Diversification Portfolio

•Financial Analyisis, e.g. mean return, Volatality, downside risk probability etc

•Corporate Governance

CRISIL Mutual Fund Ranking is the relative performance ranking of mutual fund schemes within the peer group. The basic eligibility criteria for inclusion in the ranking universe are 2 years NAV history (one-year for Liquid, Ultra Short Term Debt, Index and Debt-Short funds and five –year inclusion for the Consistent Performers),

assets under management in excess of category cutoff limits and complete portfolio disclosure. It uses Superior Return Score (SRS) to give the relative measure of the return and the risk for the schemes within the peer group, Beside Mean Return Volatility, Tracking Error, Downside Risk Probability, Diversity Scores (for Industry/company concentration), Liquidity Analysis etc. are done.

CARE’s fund credit quality ratings are based on evaluation of funds investment strategy and portfolio credit risk. It also involves evaluation of credit quality of individual assets, diversification of portfolio, management quality and operational policies. CARE uses the concept of credit scores, assigned to individual securities, as per credit scoring matrix developed by CARE.CARE’s credit scores are arrived atusing historical data on defaultsadjusted for data limitations. Creditscore is lower for higher ratingcategories and vice versa. Beside, organization setup, qualifications/experience of senior management, Operations & Risk ManagementSystems are analyzed before the final ratings come out.

ICRA uses “credit scores”based on its estimates of credit risk associated with each exposure of the portfolio taking into account its maturity.To quantify it, it uses its database of historical default rates for various rating categories. ICRA reviews relevant fund information on an ongoing basis to support its published rating opinions. If the portfolio score meets the benchmark of the assigned rating during the review, the rating is retained. In an event that the benchmark score is breached, ICRA gives a month’s time to the fund manager to bring the portfolio score within the benchmark score. If the fund manager is able to so, the rating is retained.

The final ratings by these CRAs (Only for funds having maturity of more than one year) are summarized as follow:

Comparative Rating Symbol across Credit Rating Agencies (CRA)

Source: Respective Websites of Credit Rating Agency

Note:For the rating categories, CRAs may apply '+' (plus) or '-' (minus) signs for ratings from 'AA' to 'C' to reflect their relative position within the rating categories concerned. Thus, for ICRA, the rating of mfAA+ is one notch higher than mfAA, while mfAA- is one notch lower than mfAA. Also, all ratings pertains to funds with maturity

To interpret, ICRA has recently rated SBI Capital Protection Oriented Fund ‐ Series II as mfAAA (SO), Indicating highest degree of certainty for payment of face value of the mutual fund units on maturity to theunit holders. Rating considers the fund’s equity market exposure, blended with the protection of Capital. The orientation towards protection of the capital originates from the portfolio structure of the scheme, and not from any bank guarantee or insurance cover.

More agencies giving star wise ratings

Beside the RBI registered CRAs, there are more external agencies including Value Research, Moneycontrol, Bajaj CapitalInvestors India’s(BCII) etc providing mutual fund ratings on monthly, quarterly or yearly basis. Bajaj CapitalInvestors, a magazine owned by Bajaj Group, uses “Fund Risk Grade”for rankings which capture the fund’s risk of loss. Fund Risk Grade indicates only downside volatility, referring to absolute losses and even periods when the fund under-performs a risk-free guaranteed investment. The rationale being one can always guarantee return through FDsand the risk in investing in a mutual fund not only includes the possibility of losing money, but also the chance of earning less than you would have with a guaranteed investment.

To calculate Fund Risk, weekly fund returns are compared against the weekly risk-free returns such as 180 Day T-Bill Rate, SBI 1-Year Term-Deposit Rate etc.Risk-Adjusted Rating is determined by combining the fund’s Risk score with its Return score.The resulting number is then assigned according to the pre-decided distribution

Value Research (VR), a Noida based premier research house gives similar rankings to that of Bajaj Capital with a similar methodology. To calculate Fund Risk, monthly/weekly fund returns are compared against the monthly risk-free return for equity and hybrid funds and weekly risk-free return for debt funds. Risk-free return is defined as SBI’s 45-180 days Term Deposit Rate. For all months/weeks the fund has underperformed the risk-free return, the magnitude of underperformance is added. This helps in arriving at the average underperformance and how the fund has performed vis-à-vis its category average. The relative performance of the fund is expressed as a risk score.

However, ratings cannot be the sole criteria……

Mutual Fund Ratings often tell you how a fund has performed on a risk-adjusted basis relative to a relevant category in the past. It’s a useful piece of information, but certainly not enough for smart investment decision as they can be mis-leading at times. Therefore ratings must be seen in conjunction with the investors’ appetite, eventual goals, industry dynamics etc. Following are the few shortcomings of mutual fund ratings in India:

Differences in rating methodologies: For instance, while VR and Morningstar (MS), rate funds using quantitative risk-return based metrics, and assign a 5-star rating to funds appearing in the top 10%, the former uses a simple average of the 3-year and 5 -year ratings, while the latter uses a weighted average of the 3, 5 and 10-year ratings, with more weight assigned to the longer-term rating.An investor insisting on 5-star funds may tend to overlook some good ones only because they do not make the cut in an agency's assessment.

Continuously Shifting: Investors are usually advised to hold on to funds for long periods of time. However, funds constantly enter and exit the 5-star segment. For instance, Sahara Mid Cap and Principal Large Cap enjoyed a VR 5-star rating in November 2009 but are now rated 4-star. Shuttling in and out of funds based on this may result in exit loads and taxes. Also, rarely is a fund able to hold on to the 5-star rating for a continuous period of 3 years or more. Any rating usually holds only for a certain point in time and only in relation to its peer universe.

Suitability:For an individual, choice of mutual fund is also dictated by your personal goals, willingness and ability to take risk. It may so happen that a lower rated fund may be more suitable to your individual case as compared to a higher rated one. For instance, UTI Dividend Yield Fund may not suit an aggressive investor as much as Reliance Growth Fund will, despite the former's VR 5-star rating. Besides, VR does not rate certain sector funds like Franklin Infotech, Reliance Pharma, ICICI Prudential FMCG and Reliance Diversified Power Fund, despite these being in existence for over 5 years and performing well. You can always look for disclaimers by CRAs, most of them says:  When it comes to choosing a fund, a 5-star rating is neither a necessary nor sufficient condition. What matters is whether it is a good fit in your portfolio or not.

Importance of Ethics:A fund house (or its star fund manager) that is embroiled in a scam/financial irregularity does not get a `negative rating' on ethics. So a fund house that is performing well on the returns front, although it has been hauled up by regulators for misdemeanors while investing, will still manage to get a high rating based on high returns, albeit at lower ethics. So there is a need to accord an `ethics-adjusted return' which ratings fail to do.

Not a Buy/Sell Recommendation:Above all, Mutual Fund ratings don’t recommend anything. Hence there could be a dozen equity funds in a particular peer group, all with 5 star ratings. The ratings fail to guide investors on exactly which fund is ideal for their portfolios