The new book, Index Investing: A Low Cost, Low Risk Strategy to Investment Success by Abhishek Kumar, published by SAGE Publications India, showcases Index Investing as a timeless solution to earning a fair share of market return while shielding against financial sharks to sail safely during the impending economic slowdown.
Twinkle-Twinkle Little Star
Now comes the one parameter which most of the investors usually don’t miss to catch. It is the star rating assigned to mutual funds by different rating agencies.
The first thing to understand about the star rating to mutual funds is that all it does is tell which fund has done good or bad in the past and it doesn’t tell anything—not even an iota of information— about the future. So when you invest in a mutual fund based on the star rating, what it essentially means is that you are driving a car looking at the rear-view mirror. And what will happen when you do so? Well, you will hit something. And that is what is being happening to the retail investors all this while.
Second, the star ratings of the fund are heavily based on their most recent performance. These ratings that you see in various Internet portals and in magazines are based on a composite of a fund’s record over the previous 3-, 5- and 10-year periods with more weight given to the most recent performance. As a result, the previous two years’ performance alone accounts for 35 per cent of the rating of a fund with a 10-year history and 65 per cent for a fund in the business from 3 to 5 years. A clear and heavy bias in favour of recent short-term returns.
Now the question comes, how successful are fund choices based on the number of stars awarded for such short-term achievements? The answer is ‘not very’. According to a 2014 study by the Wall Street Journal, only 14 per cent of the 5-star funds in 2004 still held that rating a decade later. Approximately 36 per cent of those 5-star funds dropped to 1 star, and the remaining 50 per cent dropped to 2 or 3 stars.[1] Yes, fund performance reverts towards the mean, or even below. As John Bogle once commented:
The stars produced in the mutual fund field are rarely stars; all too often they are meteors, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth.[2]
Now observe what happens in the real world. Out of 100 funds, 10 funds do pretty well and, thus, their net asset value (NAV) increase during their upswing and 10 funds do really bad which decrease their NAV. The 10 funds which topped the chart are now overvalued and our rating agencies seeing their past performance assign them 5 star. However, the funds which performed badly are pretty undervalued and adorn the rating of 1 star. And since our not-so-intelligent investors invest based on the star ratings, they pull out their money from the 1-star fund and put them in the 5-star fund.
Our academicians have been studying the flow of money into the funds based on the number of stars on their badge. In one such study, it was found that an amazing 97 per cent of fund inflows went into 4- and 5-star funds, while even 3-star funds experienced outflow.[3] And in a similar study, it was found out that a larger part of overall inflows to mutual funds go to those funds which were upgraded to 4 or 5 stars. Further, the funds which were downgraded to 3 stars and below witnessed the least inflow and maximum outflow from them.[4] So what investors are actually doing is that they are buying high and selling low—a perfect recipe of losing your money.
In the investment parlance, this is known as ‘hot money’ wherein naïve investors throw in their money into the hot funds glowing brightly because of their superior past performance. This superior past performance is more often than not a sign that the top is near. And even if it may not be the case, then the fact that the fund manager has been loaded with so much money that he can’t find the worthwhile investment opportunities for all its new investors to deploy their cash results into a much lower performance than what it had achieved in the past. Guess what, most of the investors are ‘hot money’ investors chasing the hottest fund available in the market.
Now don’t be tempted to think that investing in 1-star fund could help you achieve superior returns. There may be more than one reason why that fund is at the bottom. It could be the fund is charging too heavy a fee and the end result to investors is very low. It could also be that the fund manager is a lousy guy or maybe he/she doesn’t have a good support from his/her stock analysts. It could also be that he/she is betting on something else or hasn’t given much time on his/her strategy. Whatever be the reason, the fact that it’s a 1-star rated fund doesn’t guarantee in any way that it will be a 5-star fund in the next two or three years.
An excerpt from Index Investing: A Low Cost, Low Risk Strategy to Investment Success by Abhishek Kumar, published by SAGE Publications India.
[1] The Wall Street Journal, ‘Mutual Funds’ Five-Star Curse’ (7 September 2014).
[2] John Bogle, The Little Book of Common-Sense Investing.
[3] Christopher Blake, and Matthew Morey, ‘Morningstar Ratings and Mutual Fund Performance’, Journal of Financial and Quantitative Analysis (2000).
[4] Diane Guercio, and Paula Tkac, ‘Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows’, Journal of Financial and Quantitative Analysis 43, no. 4 (2007).