Understanding Mutual Fund Ratings: A Guide to Verification

Mutual fund rating companies use a variety of statistical analysis tools in order to determine the value of a fund. These ratings are available online or through the majority of investment advisers. Ratings are compiled by groups like Morningstar, Fidelity or T. Rowe Price. Some of these organizations, though, also sell the mutual funds. This can cause some conflict of interest when it comes to rating the funds. Many investors will look to corroborate a mutual fund rating in order to determine if the rating is accurate or simply a sales pitch.

Seek Multiple Sources of Ratings

Perhaps the easiest way to corroborate ratings is to look at ratings from more than one institution. The more companies that review a fund similarly, the less likelihood there is that one of the companies is acting out of personal interest. When you find there is an outlier in the ratings, look closely to determine whether that outlier, high or low, comes from a ratings institution with a personal interest in the fund. This can be hard to find since most ratings institutions will do their best to hide any personal interest. One strategy is to ask the company whether they can assist you in purchasing shares of the mutual fund. If the adviser responds that they sell shares in the fund often, then you will know there may be some personal interest conflicting with an unbiased ratings system. 

Review Statistics

Behind every rating, there has to be evidence to support the decision. If the ratings institution is willing to show this evidence, then review their reasons behind the rating. For example, some institutions will even show the formulas they use to determine whether a stock is trading above, or below market value. They will tell you the analysis is based on standard deviation, volatility, constant growth or other factors. When you know these figures are being used, you can be better assured the analysis has mathematical and fiscal reasoning supporting it. It may be useful to familiarize yourself with these terms even if you are not looking to actually perform the calculations yourself.

Watch Ratings Over Time

If you are in no rush to purchase shares in a fund, you have the luxury of watching how the ratings of a fund change over time. You may see one rating institution consistently list a particular fund much higher than the other ratings institutions. This can indicate conflicting motives. The more consistent a fund's rating over time, the more likely the rating carries merit on the market. If a fund's rating constantly jumps around, it may be a new fund or a highly volatile fund, both of which can be warning signs. Ratings changes are not always a bad thing. If you note that the ratings for a fund are generally consistent then suddenly change, this can be an indicator the fund's manager has made some positive or negative choices, depending on which way the ratings shift.