Why use the Star Rating if it is backward-looking?

By Morningstar Analysts |  17-09-20 | 

The Star Rating plots the funds' risk-adjusted returns over 3, 5 and 10 years against their relevant peer groups along a bell curve. The funds with the best historical risk-adjusted returns earn 4- and 5-star ratings.

No pretense. Here’s what you must know.

Since it is a pure quantitative, backward-looking measure, which relies only on performance, it won't tell you whether a manager or strategy has changed.

Neither will it tell you how the fund will perform in the future. We all are aware that the future need not reflect the past, and the past need not be replicated in the future.

Even if it has been a consistent performer, it may have a tough time replicating the past performance. That could be due to a fund manager change. Or, the fund might have become too big to invest in the small-cap names that catapulted it to fame. On the other hand, if the performance appears mediocre because the strategy has been out of favour, the future may be better than the recent past.

The rating can be strongly influenced by market conditions. A fund may garner a 5-star rating because it’s portfolio is chockfull with the flavour of the season – be it pharma stocks, or infotech stocks, or infrastructure stocks, or mid-cap stocks, not because the manager was especially skilled.

Over shorter periods, funds can be successful simply because of random chance. Their recent performance may put them at the top of the heap for a brief spell, but that's unlikely to remain the case over the long haul.

So why do we even bother with backward-looking Star Ratings?

Just because a data point doesn't answer all your questions, doesn't mean it shouldn't be in your arsenal for consideration. Take it for the positive it brings to the table and dig deeper.

For example, ABSL Frontline Equity has a 3-star rating, down from the 5-star rating it once boasted. Nevertheless, Morningstar’s analyst believes that the fund is a very compelling offering and should not be overlooked due to the fall in the Star Rating. It has delivered a solid showing on the risk/reward front over the long haul. Fund manager Mahesh Patil has been managing this fund since November 2005. His track record suggests he is at his best running diversified strategies in the large-cap segment.

Same is the case with HDFC Top 100 that now has a 2-star rating. But Morningstar’s analyst believes that the fund manager is supremely skilled, works with a competitive and stable team, and has high conviction in the strategy to outperform over a market cycle.

Prize the rating for what it surfaces, rather than deride it for what it does not.

The star rating is a great starting point and helps investors get a sense of each fund’s risk adjusted return. But you should not base your decision on a fund solely because of its current star rating. You need to combine it with fund analysis.

Check the Star Ratings here.

Check the Analyst Ratings here.

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