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Basis of Ratings – Risk, Return & Portfolio Quality

Introduction

A 5-Star rating is not awarded simply because a fund gave the highest returns. If Fund A generated 20% return by taking extreme risks, and Fund B generated 18% return with very low risk, a rating agency might rate Fund B higher. This chapter explains the sophisticated methodology behind ratings, focusing on Risk-Adjusted Returns.

1. Risk-Adjusted Returns (The Core Metric)

Rating agencies don't look at absolute returns; they look at returns generated per unit of risk taken.

Key Ratios Used:

  • Sharpe Ratio: Measures excess return over risk-free rate divided by total risk (Standard Deviation). A higher Sharpe ratio means better return for every unit of risk.
  • Sortino Ratio: Similar to Sharpe, but only considers "downside risk" (negative volatility). It rewards funds that rise steadily but punishes funds that crash often.
  • Treynor Ratio: Measures excess return per unit of systematic risk (Beta).

Concept:

Only verify returns that are "meaningful." If a fund manager took a gambler's risk to get high returns, the rating methodology penalizes them.

2. Portfolio Quality Attributes

Beyond returns, agencies analyze what is inside the portfolio.

For Equity Funds:

  • Concentration Risk: Is the fund too dependent on just top 5 stocks? (Higher penalty for concentration).
  • Liquidity: Can the stocks be sold easily if investors redeem?
  • Valuation: Is the portfolio P/E too high compared to peers?

For Debt Funds:

  • Credit Quality: The most critical factor. A fund holding AAA-rated sovereign bonds gets a higher quality score than a fund holding risky AA or A-rated corporate bonds.
  • Modified Duration: Does the duration align with the fund's stated objective?

3. Consistency (Rolling Returns)

Rating agencies value consistency over "one-hit wonders."

  • Instead of looking at Point-to-Point returns (e.g., Jan to Dec), they look at Rolling Returns.
  • Example: How did the fund perform in every possible 3-year period over the last 10 years?
  • A fund that beats its benchmark 80% of the time gets a higher rating than one that beats it 50% of the time with high volatility.

4. Qualitative Factors (Subjective)

Some advanced ratings (like Morningstar Analyst Rating) go beyond data and interview the investment team.

  • People: Experience and stability of the Fund Manager.
  • Parent: Strength and ethics of the AMC.
  • Process: Adherence to stated investment strategy.

Comparison: Quantitative vs Qualitative Basis

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Exam Notes: Writing the Answer

Question: "What are the parameters used for rating mutual funds? Explain the concept of Risk-Adjusted Return." (12 Marks)

Model Answer:

Parameters for Rating: Mutual fund ratings are a composite score based on:

  1. Risk-Adjusted Returns: This is the most significant weightage. It checks if the returns justify the risk taken. Key metric: Sharpe Ratio.
  2. Portfolio Attributes:
    • Equity: Liquidity, Concentration, Valuation.
    • Debt: Credit Quality (AAA vs AA), Modified Duration.
  3. Consistency: Frequency of outperformance against the benchmark over multiple time periods (Rolling Returns).

Concept of Risk-Adjusted Return: It neutralizes the "risk" factor to compare funds fairly.

  • Formula: (Fund Return - Risk Free Rate) / Volatility.
  • Significance: It reveals "Skill" vs "Luck." A manager generating high returns purely by taking excessive risk will have a poor risk-adjusted score and a lower rating.

Summary

  • Not Just Returns: Ratings = Return + Risk + Consistency.
  • Sharpe Ratio: The gold standard for measuring risk-adjusted performance.
  • Portfolio Quality: Credit quality (in debt) and concentration (in equity) are vital.
  • Consistency: Rolling returns measure the reliability of the fund.

Quiz Time! 🎯

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