Many people look at the ratings of a mutual fund before investing in them. This is what is the intention of the rating agencies! However they will tell you that ratings are backward looking (there is only Mercer which does forward looking ratings, but obviously available at a very high fee — which is fair enough).
Looking at ratings to invest in a mutual fund is pretty foolish. Also when the number of funds in a category increase, there will by definition be a lot of 5* funds. This is obvious is it not? If I were running a rating agency and I decide that the top 10% will be called 5* it is good for the business. So if there are say 500 equity funds, you will have 50 funds that will get a 5* rating. Now how will you pick 2 funds (investing in more than 4 funds is a waste of time) given the fact that you have 50 funds from which to choose. However it is good for the rating agency — all the schemes will advertise, put an asterik and say 'Subramoney has rated us 5*' — clearly I will be the biggest beneficiary.
Rating is a difficult business, done by overqualified people with impossible assumptions. Why they even rated many junk bonds as AAA, and then in 6 months down graded them to junk!
So does rating make sense? No. Not for mutual funds. For banks, company fixed deposits, etc. it may still make sense…but not for mutual funds. Frankly rating agencies should be above board, and above suspicion.
The author P V Subramanyam is a Chartered Accountant by qualification and a financial trainer by profession. Writing being a passion he also regularly pens his thought in his blog Subramoney.com
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