What criteria do rating agencies take into account while evaluating funds? Should you depend on their ratings? And can they help you spot tomorrow?s winners?
Until last year, every mutual fund you picked seemed to have the Midas touch. Each one that you placed a bet on soared. So nobody really bothered to find out about the rating of the fund, its portfolio, the performance record of its fund manager, and so on. And now, when the markets have plummeted, ratings of mutual funds are seen with a sceptical eye: if the fund has a five-star rating, why is it down 40 per cent this year? (The answer, for the uninitiated, is that when the market is down more than 50 per cent, what can the poor fund do?)
So, how important are ratings? Should you look them up before deciding to invest in a fund? Or are they mere hogwash ? like the ratings given to CDOs (collateralised debt obligations) based on subprime home loans in the US?

How is rating done
Funds are rated on a composite measure of return and risk. ?Primarily this is a quantitative method.
There is no qualitative input to it. Our ratings are based on historic risk-adjusted returns. We rate funds that are at least three years old. Any equity fund younger than that is not rated. Likewise, in the fixed-income section, funds below 18 months are not rated,? says Dhirendra Kumar, chief executive officer, valueresearchonline. com.

Take an example of two funds, say fund A and fund B. Over a three-year horizon both these funds give the same return, say 30 per cent. But their ratings may not be the same, the reason being their interim performance during this three-year period. While fund A might have given consistent returns, fund B may have gyrated wildly from year to year. In that case, fund A will have a better rating than fund B.
The three major players in the rating arena are Crisil, Valueresearch and ICRA. While Valueresearch gives stars (five-star is the best performer), Crisil ranks funds on the basis of CPR (Crisil performance ratings). There are several factors that come into play, like the age of the fund, the AUM (assets under management) of the fund house, and the number of funds in that category. For instance, in the equity space, valueresearch takes into consideration the average asset under management during the past six months.

How relevant are ratings
When the whole industry is designing newer products and hawking them like consumer goods, it is hard for investors to make a prudent choice. With a plethora of schemes available already and many more being launched at regular intervals, can ratings help investors find their way through the maze?

A cursory look at the funds rated four- and five-star by valueresearchonline shows that most of them are showing returns in the range of -30 to -40 per cent. If this elite group of funds is giving such abysmal returns, you do wonder if ratings have any relevance. Explains Kumar: ?Four- and five-star rankings mean that in that particular category these funds have in the past delivered superior returns for the risk assumed. It is a relative ranking. And it simply means that in case markets tank tomorrow, then the four- and five-star funds will stack up better compared with other funds.?

Should these ratings be considered at all while making investment choices? Certainly. However, they should not be the sole criterion for decision-making. ?I think ratings are a good starting point, but I don?t think they should be treated as something conclusive. Investors should not depend entirely on ratings only.
But given the large number of funds in different categories, making a choice can be quite a nightmarish task for investors. So, ratings are a good starting point. For instance,

for equity funds, four- and five-star rated funds are a good starting point,? says Kumar.

According to Delhi-based financial planner Surya Bhatia, ?Ratings are a good way to get a bird?s eye view of the fund before investing in it. However, an investor should find out the parameters on which ratings are done by the company. Maybe a two-year-old fund is doing really well, but it is not under the radar of the rating company because of its three-year age criterion.?

Adds Pune-based financial planner Veer Sardesai: ?It is certainly not prudent to make investment choices based solely on the ratings of an agency. Ratings can only be used as a guide. Typically, most ratings consist of an analysis of past performance and risk assumed. As we all know, past performance can only be a guide. Other factors such as the fund house?s ethics, reputation, investment philosophy, and its ability to retain fund managers are not reflected in the rankings. So ratings should serve as a guide, maybe even as a starting point in choosing a fund, but no more than that.?

While that is the case with equity funds, ratings hold a lot more importance in the case of debt funds. ?Ratings are very critical in the case of debt funds. Investors should find out the rating given to debt funds before investing in them. The crisis that we saw of late in the mutual fund space was primarily because of low-rated underlying securities in the portfolios of debt funds,? says Bhatia.

Beyond ratings
Besides ratings, investors should pay heed to several other things while choosing a mutual fund. First and foremost, take into consideration your goals. When choosing a fund a person must look at his financial goals, risk appetite, and then decide on the class of mutual fund that he will invest in, i.e., debt, equity, or balanced fund.

Thereafter, within each class one will have to further narrow down the choice. For instance, among equity funds, do you wish to invest in a small-cap fund, a large-cap fund, or a truly diversified fund? Do you want to invest in a growth fund or a value fund? Having narrowed down your choice to such sub-divisions, the investor should then pick the best funds within that sub-division based on ranking.

?From these funds, the choice in case of equity funds can be made by considering factors such as past performance (has it fetched consistent returns from year to year or have returns gyrated wildly?), size of the fund (avoid too small funds ? those with corpus less than Rs 20 crore), tenure of the fund manager (the longer, the better), cash position (look for funds with lower cash position), and so on,? says Sardesai.

The bottomline: first find out which fund category or sub-category best fits your needs, then look for the best-ranked funds within that class. Evaluate those funds on qualitative measures. If you do the due diligence ? combining the quantitative criteria of ratings with your own qualitative ones ? at the time of investing, it is likely that the fund will measure up to your expectations in the years to come.