Choosing a Mutual Fund: Beyond Star Ratings

Choosing a Mutual Fund: Beyond Star Ratings

The honest short answer: a star rating tells you how a fund did in the past, not how it fits your future. Choosing well means starting with what you need the money to do, finding funds whose mandate matches that, and only then comparing them on consistency, cost, risk and how they are run. Last year's returns and a five-star badge are the weakest reasons to buy.

Here is a cleaner way to decide.

Why star ratings mislead

Ratings are backward-looking by design. They reward funds that already did well, often because their style was in favour recently. Styles rotate. The fund that topped the charts in a momentum year can lag for the next three. Buying the five-star fund is often buying the top of a cycle. Use ratings as a rough filter at most, never as the decision.

Start with the mandate, not the fund

Before you compare anything, decide what role this money plays. A long-term wealth goal, a near-term purchase, income, tax saving under ELSS. Each points to a different category: large cap, flexi cap, mid or small cap, hybrid, debt. Picking the category first does more for your outcome than picking the fund, because the category sets the risk and return you can expect (more on matching money to horizon in asset allocation by age). A brilliant small-cap fund is still the wrong choice for money you need in two years.

What actually matters, in order

Consistency over a single big year. Look at how a fund performed across different market phases, not one headline number. Rolling returns, which measure performance over many overlapping periods, tell you far more than a point-to-point figure that can be flattered by a lucky start or end date.

Cost, because it compounds against you. The expense ratio is deducted every year, in good years and bad. Over a long horizon a small difference in cost becomes a large difference in wealth. This is also why regular and direct plans differ, which we cover below.

Risk-adjusted returns, not just returns. Two funds can post the same return while one took far more risk to get there. Measures like how a fund held up in falling markets tell you whether the returns came with a smooth ride or a stomach-churning one you might not sit through.

How it is run. A clear, repeatable process and a stable fund manager matter more than a star rating. A fund that changes its approach to chase whatever is working is harder to trust over a decade.

Size, within reason. A very large small-cap fund can struggle to move nimbly; a tiny fund carries its own risks. Size should fit the strategy.

Direct versus regular plans

Direct plans carry a lower expense ratio because they include no distributor commission, so over time they cost you a little less. Regular plans include that commission, which is how distributors like us are paid, so you pay no separate fee to us (see exactly what you pay). Neither is universally right. What matters is that you know which you hold and why.

The mistake to avoid

Collecting funds. Many investors end up with eight or ten schemes bought over the years, each a former chart-topper, that overlap so heavily they hold two funds' worth of real diversification at the cost of ten. More funds is not more diversification. A few well-chosen, well-matched funds, reviewed and managed over time, beats a drawer full of yesterday's winners.

Frequently asked questions

How do I choose a mutual fund in India? Start with the goal and time horizon, which sets the category. Within that category, compare funds on consistency across market cycles, expense ratio, risk-adjusted returns and the stability of the process and manager. Treat star ratings as a rough filter, not the decision.

Are five-star rated funds the best to invest in? Not necessarily. Ratings reflect past performance, which often means a style that was recently in favour. They can point you toward the top of a cycle. Use them to shortlist, then judge on consistency, cost and fit.

Should I pick direct or regular plans? Direct plans cost slightly less as they carry no distributor commission, but include no distributor support. Regular plans cost you nothing extra directly, as the fund house pays the distributor. Choose based on whether you want guidance alongside.

How many mutual funds should I hold? Usually fewer than people think. A small set of funds matched to your goals, with limited overlap, is easier to manage and diversifies just as well as a large, redundant collection.

Where to go from here

Choosing a fund is step one. Managing the mix over time is the harder, more valuable part, and it is what we focus on. If you would like to see how we approach it, our live webinar runs every Saturday. [Join the Saturday webinar.]

This article is for educational purposes and is not personalised investment advice or a recommendation of any specific fund. Inbestors Private Limited is an AMFI-registered mutual fund distributor (ARN 359896), not a registered investment adviser. Mutual fund investments are subject to market risks. Read all scheme related documents carefully.