Should we avoid Five Star Funds!!

Investing through mutual funds is inevitable now for all of us. One of the most commonly used selection tool is to go with the “Five Star” funds or “top rated” funds. Several websites (including Value Research, Mutual Fund India ), brokerage houses, mutual fund distributors extend this service of rating funds. Typically these funds would be established funds with a 3-5 year track record at least. Popular funds include HDFC Equity, Franklin India Prima, DSPML Equity, Reliance Gowth, SBI Magnum Contra, Sundaram Select Midcap etc.

However, we would like to take a contrarian view here and feel that fund selection should not be based only on ratings. For e.g. let us take a look at the top gainers as of today over a one year period.

Funds Fund Rating Nav (Date) 1 Year Return

Standard Chartered Premier Equity -- 23.18 (21 Feb) 65.56

Reliance Regular Savings Equity -- 25.24 (21 Feb) 62.69

ICICI Prudential Infrastructure -- 29.75 (21 Feb) 59.77

DWS Investment Opportunity 37.57 (21 Feb) 59.19

JM Basic -- 31.65 (21 Feb) 58.73

DBS Chola Opportunities 43.60 (21 Feb) 56.27

Magnum COMMA -- 24.11 (21 Feb) 54.85

Sundaram BNP Paribas CAPEX Opp.-D -- 20.39 (21 Feb) 52.51

Taurus Discovery Stock 24.72 (21 Feb) 52.50

(Source: Value Research)

The interesting point is that NONE of them is a five star fund!! Even given that the top funds are rated based on risk -adjusted returns, one would expect to find at least one star rated fund amongst the major gainers.

A few reasons why this might be the case

1. A track record of three & five year returns is taken into account while rating funds. This takes into account the consistency of the fund. But often funds find it difficult to sustain such returns in the long run. The original strategy adopted 2/3 years back may no longer be relevant now.
2. Safety lies in numbers - It is very difficult to criticize a distributor for having recommended popular funds like Sundaram Select Midcap. As a fund becomes successful it attracts a large set of investors. The increased asset base makes it difficult to generate high returns.
3. Fund manager turnover contributes to this though it might not always be the case. Prashant Jain (HDFC Equity) and Siva Subramaniam (Franklin India Prima) continue to manage their funds for an extended period of time. Manager fatigue and lack of motivation might come into play.

So what is the solution? One approach might be to purchase ETF’s, which follow the major indices (large cap and small cap). We will discuss different approaches going forward, but please do refrain from buying into large established funds just based on fund ratings!!