Mutual Fund star rating methodology is a measure of its performance with respect to the returns, risk, and the fund’s capacity to generate returns at a particular level of risk. This rating system primarily focuses on comparing the performance of the fund within its category. Apart from the comparison, factors like Date of inception, YTM, Expense ratio, etc. also play a vital role in the rating process.
Fintoo rates Mutual funds on a scale of 1 to 5, with 5 stars representing the highest rating. Overall, this approach simply offers a glimpse of the fund’s performance in comparison to other funds in a similar category.
We have essentially divided the ranking into two categories:
Equity Mutual Funds Rating:
If a mutual fund scheme invests more than 65% of its total assets in the equity shares of various companies, it is referred to as an equity mutual fund and it includes all mutual funds other than debt and gold, such as large-cap, small-cap, mid-cap, hybrid, sector, etc. Our general Mutual Fund rating criteria for equity funds are as follows:
Returns:
40% (2 Stars) The weightage has been given to returns. Performance is produced by combining the ratings from various time periods—the most recent 1 year, 3 years, and 5 years. Weightage has been assigned to each year, with the most recent ones receiving the maximum weightage – 1 year: 40%, 3 years: 30%, and 5 years: 30% respectively. Rating is assigned by calculating the difference between returns for the particular year and its category average return.
Risk:
Again 40% (2 Stars) The weightage has been given to risk, which is equally important. To determine correctly, a combination of three ratios is being used. Ratios and their respective weightage are Standard Deviation (20%), Sharpe Ratio (40%), and Sortino Ratio (40%).
- Standard Deviation: It is a statistical measure which indicates the deviation of the scheme’s returns from its average annual returns. Higher the standard deviation, the higher the volatility. An example of this can be, If a mutual fund scheme has an average return of 15% and a standard deviation of 5, this indicates that the returns may vary by 5% on either the higher (i.e., 20%) or lower (i.e., 10%) side. Again, the rating is assigned by calculating the difference between the standard deviation for the particular scheme and its category average standard deviation.
- Sharpe Ratio: The return generated by a fund per unit of risk taken is indicated by the Sharpe ratio. It can be calculated by taking the difference between the return earned from the fund and the return earned from a risk-free investment and dividing it by the fund’s standard deviation. Therefore, a higher Sharpe ratio is always considered to be good. Rating is given to the funds by taking the difference between the Sharpe ratio for the particular scheme and its category average Sharpe ratio respectively.
- Sortino Ratio: The additional return for each unit of the downside risk is calculated using the Sortino ratio, which is a risk-adjustment statistical method. A higher Sortino Ratio indicates that the mutual fund scheme is less likely to experience a downside deviation and hence investors will receive a higher return. The difference between the Sortino ratio for the particular scheme and its category average Sortino ratio is taken to assign ratings to the funds.
Other Factors (AUM, Date of Inception, and Expense Ratio):
20% (1 Star) The weightage has been assigned to other factors, and under this, AUM has been given 40% weightage, Expense Ratio 40% weightage, and Date of Inception 20% weightage respectively. A combination of these three sub-factors will provide a calculated ranking for the funds.
- AUM: The difference between AUM in Cr. and its average Benchmark is calculated to give the ranking. Higher AUM gets a higher score as compared to the funds with lower AUM.
- Expense Ratio: To provide scores to the funds, the difference between the Expense ratio and average expense ratio is taken. The lower the expense ratio of the fund, the better the rank.
- Date of Inception: The difference between the date of inception and the current date is considered. If the fund was incorporated 3 years prior to the current date then the fund will be given a rating.
Debt Mutual Funds Rating:
Debt funds provide returns by lending the invested money to the government and private businesses. For instance, only banks and public sector entities are lent money from banking and PSU debt funds. We have considered a few additional parameters while rating Debt Mutual Funds which include YTM, Modified Duration, and Credit Rating. These new parameters along with risk-adjusted returns are used to derive the ranks for debt mutual funds. To balance out the additional parameters, ratings have been revised in the case of debt mutual funds.
Returns:
40% (2 Stars) The weightage has been given to the returns. Performance is produced by combining the ratings from various time periods including 1 year, 3 years, and 5 years. Weightage has been assigned to each year, with the most recent ones receiving the maximum weightage – 1 year: 40%, 3 years: 30%, and 5 years: 30% respectively. Calculating the difference between a year’s returns and the category average return is how ratings are determined.
YTM, Modified Duration and Credit Rating:
These new parameters in combination have been allotted 20% (1 Star) weightage in the overall ranking of the debt mutual funds.
- YTM: YTM as a sub-parameter has been assigned 50% weightage. Debt mutual funds consist of corporate and government bonds as underlying assets. It indicates the total expected return from the debt fund if held till maturity. YTM assumes that the investor has invested all of the bond’s coupon payments back into it until it matures. Again for our calculation, the difference between YTM of the funds and the average category YTM has been taken. The higher the YTM, the higher will be the rating.
- Modified Duration: This sub-parameter has been given 50% weightage. Modified Duration, highlights a security’s interest rate sensitivity. It demonstrates how significantly the value of the debt mutual fund will change in response to changes in interest rates. The idea behind modified duration is that interest rates and bond prices fluctuate in opposite directions (inversely proportional). For example, if the modified duration is 3 years, a 1% decrease in interest rates will result in a 3% increase in the bond’s price and vice versa. In short, this indicates interest rate risk. The higher the Modified Duration, the lower the rating. Again, the difference between modified duration in years and average category modified duration has been calculated in order to provide a rating.
- Credit Rating: Credit rating is given to debt mutual funds by rating agencies like ICRA, CRISIL, Fitch, etc. The credibility to repay the loan by the government and private entities which has been lent by the investors is given ratings by these agencies. We dedicate ratings in our logic by taking the difference between the credit ratings given to the debt funds and the category average credit rating. Lower the credit risk better will be the fund.
Risk:
To balance the new parameters, the rating assigned to risk has been reduced to 20% (1 Star). In order to determine the rating, a combination of the risk ratios and their respective weightage is Standard Deviation (20%), Sharpe Ratio (40%), and Beta (40%). Standard Deviation and Sharpe Ratio’s calculation and interpretation remains the same as mentioned in the equity mutual fund section to determine the ranks.
- Beta: The beta of a mutual fund is a measure of the fund’s expected volatility in relation to the market (Benchmark) as a whole. When a fund’s beta is greater than one, it indicates that it is more volatile than its benchmark, and when it is lower than one, it indicates that it is less volatile. The difference between the beta of the funds and the average beta for the category is taken to assign the rating.
Other Factors (AUM, Date of Inception and Expense Ratio):
This parameter has been given 20% (1 Star) weightage. Again, sub-factors remain the same as in the equity mutual fund section. Under this, the weightage assigned to AUM, Expense Ratio, and Date of Inception is 40, 40, and 20 percent, respectively. These three sub-factors taken together will give the funds a determined rating.
Mutual fund ratings are given after performing in-depth research on all the vital aspects that not only signify the fund’s past performance, but also help you to make assumptions about the fund’s performance in the future as well, and ultimately select the right fund that matches your requirements. These rankings do not reflect our views on the funds but are just a logic-based assessment of the past data of the Mutual funds with respect to their category or benchmark respectively.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.
