Imagine you are on your investment app, getting ready to start investing afresh in mutual funds, or to add more to your kitty. And you think, what is the best way to find the best funds for me. You go to Google and make a simple search “Best Mutual Fund”. A search term that has a search volume in the millions.
You finally land on the website of a well-known fund house and see this shiny 5-star rated mutual fund. It is hailed as the next star, a “Winner” if you will. Suddenly, you start feeling confident and smart. You hit the accelerator, put in your hard-earned money and wait for returns to start rolling in.
This is what many mutual fund investors do. They believe solely in star ratings. Almost blindly. But is this the best way to find the best funds for yourself?
Twinkle Twinkle – How i wonder what you are
Let us begin with an explanation.
What is a star rating?
In simple words, they are like report cards for funds. Research houses crunch past returns of the fund and the risks it has taken over a period of 3, 5, or 10 years. A larger number of stars mean the fund did great. Perhaps this can be interpreted as it delivered what was promised in the past. Now bear with me, isn’t this the exact opposite of what we have been told for decades – Past performance is not indicative of future results.
Investors tend to fall in love with anything that simplifies decision making. It could be SMS tips, Telegram chats, or, as in this case, a simple rating. A 5-star fund is a buy, a 1-star fund is an avoid.
But here’s the catch: Ratings look backwards, not forward.
You trust the stars and put in your hard-earned money. And sometimes, you end up with a poor experience.
The data: When 5-star funds fail
And this is not just fear-mongering. Data backs it up! According to Economic times, between January and April 2025, 97% of equity funds gave negative returns. Even the 5-star rated “Winners” from before failed to perform. Now of course, the counter to this could be ratings are suggestive of long-term performance and cannot be held accountable for near adverse movements of a fund. Fair point. But the larger question that remains to be asked, how helpful ratings really are, if all they are suggesting is that one drive forward, while looking into the rear-view mirror.
Now before we say anything else, let us be very clear that we are not saying that all star ratings are bad. It is a good tool to judge the fund on some parameters. The problem begins when it is taken as the ONLY guiding light to pick funds.
SPIVA’s 2025 mid-year report put it brutally. For H1 2025, 76.9% of tax-saver funds lagged when compared against benchmark index. The reports said, “The S&P India BMI gained 5.2% in H1 2025, and 76.9% of Indian ELSS funds underperformed the index. Underperformance rates were 35.9%, 52.6%, 68.3% and 86.8% over the 1-, 3-, 5- and 10-year horizons, respectively”.
So, you see, the best funds might skip this star rating system overall.
Lack of Awareness? Not Much
AMFI (Association of Mutual Funds in India), the governing body for mutual funds in India, spends a lot of money in promoting and creating awareness about mutual funds. Basically 0.01% of the total AUM (Assets Under Management) in India. At the end of September 2025, this AUM was Rs 75.61 Lakh Crores. Which means AMFI spends roughly over Rs 750 cr on ads and awareness programs.
And this apart from the money fund houses spend for the same. You see, as per a SEBI guideline, fund houses must spend 0.02% of their AUM on awareness. And half of this they give to AMFI, which is where AMFI’s share of 0.01% comes from.
And AMFI’s official investor education materials, including their main “Investor Awareness presentation” and the “Mutual Funds Sahi Hai” campaign, do not list star ratings as a recommended parameter for selecting a mutual fund.
The Awareness Paradox: Money Spent, Message Missed
So, all this money spent on awareness, but investors still rely, sometimes solely, on star ratings.
To share an example, a popular large-cap fund was one of the strongest funds in the pre covid era. It had the 5-star rating. But that was years ago. Five-year returns for the fund today are 15.83% vs. benchmark 19.56%. Lagging by almost 4%. No wonder it was demoted to a 3-star rating. The fund also had corporate governance issues, which the rating could not have anticipated.
So, the ratings, which work by looking into the rear-view mirror, are operating exactly as they should. The question is, how is the investor to know which fund to pick and which fund to exit? Ratings alone may not help much with that.
Here’s another example. A small cap fund from another AMC, dropped from 5 to 4 stars in the last 3 years as it clocked 18.2% vs. Nifty Smallcap 250’s 22.5%, a difference of 4.3%. Now, this may look like horrible performance, but perhaps, the fund manager decided to take on a lot less risk given the uncertainty. This worked to the fund’s disadvantage as the markets, on a point-to-point basis, turned in a surprisingly good performance. So, while the ratings are right from their perspective, one may be tempted to side with the fund manager too.
Case Study: The 4-Star Fund That Won
But here is the big twist. While many are busy looking for the star ratings, there are some that win silently. Yes, a lower-rated fund can beat the 5-star champions. Take for example Quant Small Cap Fund, Despite often holding a 4-star rating, it has been the number one performer in the entire small-cap category. It delivered a staggering 5-year annualized return of around 35%.
The Nifty Smallcap 250 index (which it’s measured against) delivered 30% in the same period while the average 5-year return for all small-cap funds was only about 29%.
You see, adaptation is what makes or breaks it, not past data.
You see, we are not saying that skip the star ratings completely. They are after all a good tool to know how funds have performed till now. But that cannot be the only criterion for picking funds.
What to Do Instead: The 3 Pillars of Smart Investing
AMFI’s investor awareness highlights 3 main criteria to consider before picking a fund to invest in.
#1 Financial Goals (Why are you investing?)
#2 Risk Appetite (How much volatility can you handle?)
#3 Investment Horizon (How long can you stay invested?)
One must also always look into the fund manager’s past history, calibre, credentials.
And don’t put all your eggs in one basket. Mix it up with active and passive picks. For context, indexes beat 80-90% active funds in the long-term, as per SPIVA (S&P Indices Versus Active). Look at rolling returns over 10 years, fund manager tenure (5+ years at least), and they must align with your goals.
Disclaimer:
The purpose of this article is only to share interesting charts, data points, and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your advisor. This article is strictly for educative purposes only.
Suhel Khan has been a passionate follower of the markets for over a decade. During this period, he was an integral part of a leading Equity Research organisation based in Mumbai as the Head of Sales & Marketing. Presently, he is spending most of his time dissecting the investments and strategies of the Super Investors of India.
Disclosure: The writer and his dependents do not hold the stocks/securities/funds discussed in this article.
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