The business of evaluating mutual funds has expanded from a quarterly rating service to multimillion dollar industry. In most cases, the rates can make or break a fund. But the question is: can investors rely on mutual fund rating?

  • The Lipper Rating System - The rating system evaluates mutual fund and hedge fund, and provides commentary and tools for analyzing data. Lipper Leaders, the firm’s proprietary rating system, encompasses over 80,000 funds and employs capital preservation, consistency, expense management, and peer performance, among other factors, as guiding principles. It uses a scale of one to five, with five being the highest score.
  • The Morningstar Rating System - It also uses a ranking system, but uses stars for their rating standard. Tailored to investors’ preferences, it provides both hard copy and soft copy of their reports. Morningstar also has a nine-square style box designed for both equity and fixed-income funds. In comparing weighting decisions, the firm shows breakdowns for equity funds into 12 industry groups within three principal economic sectors.

Arguably, performance is the most significant component of mutual fund ratings. But looking after performance entangles many investors into the performance trap. This is when money flows heavily into a fund which was highly valuated in the past year. In most instances, the same fund does not generate such profits in the following year. This is where consistency comes in. Rating entities need to apply apt knowledge and expertise to deeply assess a fund’s performance based on absolute, relative factors.

But one of the largest problems with rating a fund is investors and rate funds tend to be complacent in times of a long-term bull market. And fund managers are vulnerable to any temptation to raise performance or protect against downside risk when markets are volatile. Not to mention it takes time - a lot of time - to become a highly-rated mutual fund.

Evaluating mutual funds have become an industry itself for the longest time. Although an investor cannot fully depend on these ratings, it can render a good guidance and direction for gaining decent returns.