Quartile Ratings for Mutual Funds in India

Sep 20, 2017 / Dwaipayan Bose | 198 Downloaded | 8742 Viewed | |
Picture courtesy - GrpahicStock

You will often come across blog posts like “Best mutual funds for SIPs”, “Best funds for investment in 2017”, “Best 5 tax saving funds” or “Best Mutual Funds in India“ etc. While these blogs can be interesting reads for investors, they should be prudent when applying the contents of these types of blog posts, in their investment decisions. Let me explain the problems, investors may face, when they directly apply the information from these type of best funds posts in their investment decisions.

Firstly, when you come across a post like “Best funds for investment in 2017”, a literal interpretation of the title may lead investors to believe that, these funds will give the highest returns in the future. No matter, how robust methodology the blog authors employed in identifying the best funds, there is absolutely no guarantee that funds which outperformed in the past will outperform in the future as well. Expecting a fund to give you the highest returns on a relative basis in the future, is setting wrong expectations for yourself.

Secondly, I have seen that, the best fund list changes every year, though there may be some repeat candidates in the list from last year. If you invested in a so called best fund and you find that the fund is not in next year’s best fund list, will you exit the fund and invest in one of the best funds in the current year? Investment experts will tell you churning your mutual fund portfolio too often will result in sub-optimal portfolio performance.

Thirdly, there is a tendency among many investors, of trying to select the best of the best Mutual Funds in India. This is mostly a futile endeavour, because funds may outperform others on some parameters, while it may underperform on some other parameters. For example, some funds may give higher returns than other funds, but may also have higher volatility than others. Some funds may give high returns, but may have concentrated portfolios. Some funds may be biased towards a market capitalization segment and will outperform when that market cap segment outperforms.

Finally, while some bloggers describe the methodology used to identify best funds, many do not. There is no standard methodology (there cannot be) to identify best funds. Different bloggers / websites use different methodologies, using a combination of factors (depending on how sophisticated their fund selection process is) like trailing returns, standard deviations, performance in down markets, performance consistency, concentration risks etc. No methodology is perfect; some methodology may have a better statistical record of predicting future outperformance, but unfortunately there is no statistical study we are aware of, that provides statistical evidence of superiority of a particular methodology (used by bloggers, research websites) in predicting future outperformance while selecting best Mutual Funds in India.

The difficulty in identifying the best funds for investment is that, you have to depend on historical returns, despite the standard disclosure of all mutual fund schemes which says that, historical returns is not an indicator of future returns. An alternative approach, as a user mentioned on our website’s comment section, is to look at the stock selection and churning of the fund manager. This approach may work in theory but it does not work in practice because if, investors can determine whether the stock selection is good or bad, why would they invest in mutual funds and not directly in stocks? Some investors and financial advisors look at portfolio turnover ratios of funds and if they see high portfolio turnover in a particular year, they say that fund manager is clueless. There can be multiple reasons, why a fund manager churns his / her portfolio in a particular year and unless you see a normative behavioural pattern of portfolio churning, it is unwise to pass judgements on portfolio turnover.

My philosophy with regards to mutual fund investments is that, it should be simple, so that investors are easily able to understand the investment rationale and thereby make the right investment choices. I must highlight the difference between right and best investments. Right investment helps investors meet their investment goals, while best investment is purely conjectural from a future returns standpoint.

Instead of trying to get the highest future returns, investors should focus on their goals and invest in mutual fund products which give them a reasonable degree of confidence that their goals can be met in the long term. Performance stickiness or consistency is an important factor, which gives investors confidence whether a particular product can help them meet their financial goals. Quartile rating or ranking is a performance measure, where there is some statistical evidence of performance stickiness.

What is quartile rating / ranking?

On any performance parameters, mutual fund schemes are separated into four performance quartiles. Quartile is simply a division of schemes into four equal groups. Each group represents a particular performance level. The top quartile indicates the best performance level. The upper middle quartile indicates above average to average performance. The lower middle quartile indicates average to below average performance. The bottom quartile indicates poor performance on a relative basis.

An important feature of quartile rating / ranking which investors should note, is that there is no further sub-divisions beyond the four quartiles. For example, if a fund is in the top quartile, we do not attempt to check if it is in top 3 or top 5 or top 10. Similarly, if a fund is in bottom quartile, then we do not try to find out, if it was the worst performer among other funds in bottom quartile. The intrinsic simplicity in quartile rating / raking is one of the most useful characteristics of this performance measure. The mathematics of how we do quartile rankings may be a little complicated for average retail investors but it does not matter; mutual fund research websites, including www.advisorkhoj.com provides quartile ranking of mutual fund schemes on various parameters. Simply focus on the quartile rating or ranking instead of how we came up with it.

Another useful characteristic of quartile rating / ranking is the statistical evidence of performance stickiness. Funds which are in the top 2 quartiles have a good probability of being in the top 2 quartiles. Performance stickiness is seen more in the bottom two quartiles, especially the bottom quartile. Funds which are in the bottom quartile especially, will more likely than not, remain in the bottom quartile in the coming years. Quartile rating / ranking can help you, therefore, to eliminate funds from your selection. Quartile rating / ranking can also help you vet the investment recommendations of your financial advisor.

Limitations of quartile ratings / rankings

Quartile rating is based on a statistical methodology. Any statistical methodology which is used to determine mutual performance may be mathematically sound, but may have practical limitations. While the performance differential of funds in the top and bottom quartiles will be very distinct, the performance distinction of funds in the two middle quartiles, particularly funds in the lower end of the upper middle quartile and upper end of the lower middle quartile, may not be quite definitive.

A few basis points of returns may separate funds in upper middle quartile and lower middle quartile. So investors should exercise judgement, when evaluating funds which fall in the cusp of the quartile boundaries.

How to use quartile ratings / rankings?

Unfortunately, most mutual fund websites in India do not use quartile ratings / rankings. This is because most mutual fund websites in India are distribution oriented; but research oriented websites, including our website www.advisorkhoj.com have quartile ratings / rankings on various parameters.

The most common use of quartile ratings / rankings is in annual returns. But annual quartile ranking by itself, in our opinion, has very limited use. We have discussed a number of times in our blog that, mutual fund investments are long term in nature and therefore, 1 year quartile ranking of funds is of limited use. However, quartile ratings / rankings can be assigned for a number of performance parameters other than annual returns.

Quartile ratings or rankings are compiled by sorting the funds based on different performance parameters. Funds in the top 25% are assigned the ranking of "Top Quartile", the next 25% are assigned a ranking of "Upper Middle Quartile", the next 25% after that are assigned a ranking of "Lower Middle Quartile" and the lowest 25% are assigned the ranking of "Bottom Quartile".

In advisorkhoj.com, for example, we have quartile ratings / rankings of funds on the basis of trailing returns (3 years, 5 years etc).We also show quartile ratings / rankings of funds on the basis of trailing returns over the past few quarters, so that our users can know, if a particular quartile ranking is a flash in the pan or has the fund manager been able to sustain the fund rating over several quarters. Please see our quartile rating / ranking tool, Mutual Fund Quartile Ranking.

Another use of quartile rating / ranking is to determine relative volatilities of a mutual fund scheme versus other schemes. There can be two types of volatilities, total volatility and downside volatility. Total volatility measures the deviation of the fund returns from the average over a period which includes both up and down market. Total volatility quartile rating ranks funds into four volatility quartiles ranging from top quartile (lowest volatility) to bottom quartile (highest volatility).

Downside volatility focuses only on downside risks, i.e. deviations from average in down markets. Our experience tells us that, retail investors are primarily, if not solely, concerned about downside volatility. In Advisorkhoj.com we have developed a tool that shows downside volatility quartile rating for mutual fund schemes. Funds with lowest downside volatility quartile rating are assigned the top quartile ranking, while funds with highest downside volatility quartile rating are assigned bottom quartile ranking.

One of the best uses of quartile rating / ranking is in determining performance consistency. Regular readers of Advisorkhoj blog know that consistency is one of the most important, if not the most important, performance characteristics of mutual funds. Funds which are able to retain their ratings in the top two quartiles over several years (covering periods of both up and down markets) are the consistent performers.

In Advisorkhoj, we show the most consistent performers based on annual quartile rankings performance consistency over the last 5 years in our tool, Top Consistent Mutual Fund Performers. Historical returns data analysis shows that, consistent performers tend to give superior returns in the long term.

One thing investors should note about quartile ratings / rankings is that, it is specific to a particular product category. An equity fund cannot be compared to an income fund or balanced fund; similarly, even within equity funds, a large cap fund cannot be compared with a midcap fund. Quartile rating / ranking of a fund is only relative to funds in the same product category.

Conclusion

In this post we discussed a number of mutual fund quartile rating / ranking tools. You should use a combination of two or more of these tools to shortlist and also filter your mutual fund selection for your specific investment objectives. Performance consistency is important and therefore, you should ensure that mutual fund schemes selected by you for investment are consistent performers. You should also consult with a financial advisor, if required, to identify best mutual funds in India that are best suited for your investment needs.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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