Mutual Fund Ratings Explained

A mutual fund employs investment advisors who pool together people's money and invest in stocks, bonds, and other securities in accordance with the fund's mandate. People, who invest in a mutual fund, are issued shares that have sufficient liquidity, thus ensuring that the investors can sell shares that have appreciated in value and accrue capital gains.

Investors also receive interest and dividend income, that may be disbursed as money or additional fund holdings. Though the fund's investment advisors are registered with the SEC and expected to have expertise in selecting appropriate investments, the investor has the responsibility to evaluate a fund's prospects before undertaking an investment.

This may seem like a daunting task but with a bit of research, one may be able to distinguish a performance oriented fund from a non-performing one.

Mutual fund rating agencies save investors the time and the effort of having to assess the funds on their own. Generally, people rely on the ratings provided by Morningstar and Lipper. Both Morningstar and Lipper use a ranked system of ratings.

Morningstar uses stars while Lipper relies on numbers. The stars or the rankings are assigned in ascending order of performance. The best performing fund has a 5 star rating (Morningstar) or ranks 5 on a scale of one to five (Lipper).

Analyzing the mode of assigning ratings to a domestic equity fund may help us understand the manner in which Morningstar assigns ratings. It categorizes a domestic equity fund into one of the following 9 categories, viz. Large value, Large blend, Large growth, Small value, Small blend, Small growth and Medium value, Medium blend and Medium growth.

To classify the equity fund into one of the aforementioned categories, the underlying stocks in the mutual fund are classified on the basis of valuation and market capitalization.

Relative valuation helps  to classify stocks as undervalued or overvalued. The ratio between the market price of a stock and the earnings per share gives P/E. The P/E of a stock is compared to a benchmark and a stock with a P/E ratio, higher than the benchmark is termed as a growth stock, while a stock with a lower P/E ratio is a value stock.

PEG, which is ratio between P/E and growth rate of the stock, should be used with P/E to determine whether the high P/E is really justified by the growth rate. Funds, that demonstrate both growth and value characteristics, are called blend funds. In other words, we have a table with 3 columns, viz. growth stocks, blend, and value stocks.

Market capitalization, defined as the product of the current price of a share with the number of outstanding shares, is used to classify each of the underlying stocks in a domestic equity mutual fund as large cap (large), mid-cap (medium) or small cap (small). Thus, we end up with a style box of 3 rows of market capitalization and 3 columns of valuation.

Classifying each underlying stock of the equity fund on the basis of valuation and market capitalization, culminates with the classification of the fund into one of the aforementioned nine categories.

After categorizing a fund into the style box, its past performance is compared to other funds within the same style box, and stars are assigned on the basis of risk adjusted returns. Just like the domestic equity style box, Morningstar offers the international equity style box and a fixed-income style box. It also provides gold mutual fund ratings.

Lipper also categorizes funds before comparison. But, it does not compare the fund to other funds of the same category, it compares them to a benchmark for each category. Moreover, the process of categorizing reflects the areas where the fund invests, the amount of flexibility used by the fund manager, and the extent to which it is aggressively managed.

Morningstar and Lipper assign ratings by comparing the fund's past performance with that of comparable funds within the same category, and with the benchmark for each category respectively. Since past performance is not indicative of future results, it is not prudent to rely solely on ratings of mutual funds.

One needs to look at the performance of long tenured fund managers, the Expense ratio and the Turnover ratio in addition to ratings. Absence of load fees or low load fees in addition to low/no 12b-1 (promotion and distribution) fees are some of the characteristics of a good fund.

The ratio between the fund's annual operating expense, and it's average net assets gives the Expense ratio. A low expense ratio is again a desirable feature. The mutual fund's turnover is defined as the ratio between the gross sales proceeds and the total assets of the mutual fund. Frequent trading reduces returns on account of high commissions and spreads.

Moreover, the shareholder is expected to pay taxes on the yearly capital gains, that are received, thus diminishing return on investment. Hence, a low turnover ratio is favorable. It's also sensible to investigate whether the fund manager believes in his/her picks and invests heavily in the fund.

Going through the Statement of Additional Information (SAI) will help an investor determine, whether the fund manager invests in the fund. It's evident that top-rated mutual funds need not be the best performers, since past cannot be relied upon to predict the future.