Your fund's star rating has dropped. Now what?

Who likes to watch a movie if it's rated 5-on-10 on IMDb?

We don't blame you if you, similarly, ignore mutual funds that are rated poorly by Value Research. (Hmm, you can say that Value Research ratings for mutual funds is what IMDb is for movies. #HumbleBrag.)

It's even worse when the rating of the mutual fund you invest in has declined. You feel you picked a loser. You lose faith, your day gets ruined, and, hey, who can blame you?

But does that mean you should chuck the so-to-speak underperformer and look for greener pastures?

Before we answer that question, let's explain how we rate mutual funds and the reasons it takes its twists and turns.

The star system

If you check our website - or even go on popular fintechs like Groww and ETMoney, among others - you'll observe that each mutual fund is rated out of five stars. We provide that rating.

These funds are assigned stars by comparing risk-adjusted performance against their direct peers. For example, a 'direct' small-cap fund's returns will be compared with another 'direct' small-cap fund.

So, if a fund's performance trips up, its stars take a tumble, too. (Our number ninjas are hawkish that way.)

Rating tweaks are more common than you think. Take notable funds like Axis Midcap Fund and SBI Small Cap Fund for example. Their stars faded from 5 to 3 and 4 to 3 over the last 12 and six months, respectively.

Now, let's answer the question you have come here for.

What to do with your fallen angels, erm, funds?

Interestingly, even top-tier funds aren't immune to rating fluctuations. Over a 10-year period, it's not unusual to see numerous high-performing funds dip below three stars at certain points. Such temporary downturns are part and parcel of the mutual fund landscape - just like an A-list film director making a few forgettable films.

Heck, even the direct plan of HDFC Mid-Cap Opportunities Fund, a giant in terms of AUM, saw its rating descend from 4 stars to 3 in 2019 and lingered there for four years before rebounding to 4 stars in 2023.

This shift suggests that a rating drop doesn't necessarily blow a hole into a fund's enduring quality or prospects.

In fact, even the best mutual funds can hit speed bumps, and a knee-jerk reaction can lead to regret.

Instead, it's essential to understand the market context. A fund may be underperforming due to various reasons. Maybe their investing style is temporarily out of fashion or their invested stocks are being too stubborn. The reasons for short-term bumps are many.

So, making decisions solely based on a rating change can be hasty. Patience is often a more prudent approach.

What you should do

Consider the age of the fund.

A relatively new fund, say four or five years old, that experiences a swift decline in ratings might need closer monitoring.

If there's a significant drop for such a fund, consider re-evaluating your investment in the subsequent three to six months.

For funds with a proven track record spanning 15-20 years, cut them some slack.

If there aren't any concerning indicators and the fund has consistently performed well in the past, you should allow it a year or two to bounce back from a rating dip.

That said, keep an eye on the fund's performance, as it may be getting affected by a change in the fund manager, a swift increase in fund size, or sudden surges in inflows - issues that are concerning.

The last word

Value Research ratings are just one of the many metrics you should consider. It's a trailer, not the entire film.

Enter Value Research Premium.

Here, we have a section called Analysts' Choice. Here, we not only look at the quantitative data but also factor in the qualitative aspects. Our team of seasoned analysts identifies funds best suited for you. So, consider subscribing to our Premium service for our curated list of 'Best Mutual Funds'.

Also read: Why does Value Research change the rating of any mutual fund?