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Five years ago, I used to look at star ratings before picking mutual funds. So did everyone I knew. So did most of the advisors I respected.
What star ratings actually measure
Here’s what star ratings measure. They look at a fund’s performance over the past three to five years, adjust for risk, compare it to its category, and assign one to five stars. Five stars means it has been the best performer recently. One star means it has been the worst.
Sounds reasonable. Until you ask a different question.
Does a five-star fund stay five stars?
The mean reversion problem
Studies in both Indian and global markets have found something uncomfortable. Top-rated funds in one period have only a slightly better than random chance of being top-rated in the next period. Often worse. Mean reversion is brutal in finance. The fund manager who outperformed for three years is just as likely to underperform for the next three.
What predicts future fund performance
This isn’t because ratings are rigged. It’s because past performance is mostly noise. The best three-year performers usually had favorable conditions for their style, and those conditions don’t last.
So if star ratings don’t predict the future, what does?
The four filters that work
Four things, in my experience.
How to build a checklist that helps
The expense ratio. This is the one variable you can actually control. Lower expenses mean more returns to you. The data on this is overwhelming. Cheap funds beat expensive funds in the same category, more often than not.
The fund manager’s tenure and consistency. A fund manager who has run the same fund for 10 years through different market regimes has shown they can adapt. A new manager with a hot streak hasn’t.
The fund’s mandate clarity. Multi-cap means different things at different funds. Read the actual investment philosophy and look at the portfolio. If you can’t tell what the fund actually does from looking at it, that’s a red flag.
The portfolio overlap with what you already own. Adding a fifth large-cap fund to your portfolio doesn’t diversify anything. It just adds fees. Look at the top 10 holdings of any new fund against what you already own.
What I do now.
I look at the philosophy first. Then the manager. Then the cost. Then the holdings. I almost never look at the rating.
When I compare two funds with similar everything, I take the cheaper one. When the philosophy doesn’t match my goal, I skip both even if one has five stars.
Star ratings aren’t useless. They’re a starting point for a list of candidates. But making them the final filter is how most retail investors end up with portfolios that look great in the rearview mirror and disappoint going forward.
Ratings tell you what already happened. Your money lives in what happens next.
