Mutual Fund "Star Ratings": Why 5-Star funds often become 3-Star funds (Reversion to Mean).

The "Rear View Mirror" Investing

You open MoneyControl or Value Research. You sort by "5 Star Rated Funds". You pick the top one. "Quant Small Cap Fund" or "Parag Parikh Flexi Cap". You invest ₹5 Lakhs. 3 years later, the fund is a 3-Star fund and underperforming coverage.

Why does this happen? Why do "Best Funds" rarely stay the "Best Funds"?

Because Star Ratings are a measure of History, not Chemistry. Investing based on Star Ratings is like driving a car while looking only at the rear-view mirror. You will crash.

Let's decode the First Principles of Mean Reversion and why chasing stars is a losing game.

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Part 1: How Star Ratings are Calculated (The Math)

Rating agencies (CRISIL, Value Research, Morningstar) use a Bell Curve.

• •Top 10%: 5 Stars.
• •Next 22.5%: 4 Stars.
• •Middle 35%: 3 Stars.
• •Bottom: 1-2 Stars.

The Input: Past 3-Year and 5-Year Returns (Risk-Adjusted). The Problem: If a fund took high risks and got lucky in the last 3 years (e.g., investing in Adani stocks before a rally), it gets 5 Stars. But "Luck" is not rigorous. When the cycle turns (e.g., Adani stocks correct), the fund crashes. The Rating drops AFTER the crash. The stars change after you have lost money.

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Part 2: The "Reversion to Mean" Gravity

In finance, there is a powerful force called Reversion to Mean.

• •Rule: Nothing outperforms forever.
• •If a fund generates 25% returns (while market is 12%), it is an "Outlier".
• •Statistics say: Outliers are pulled back to the Average.

Why?

1. •Asset Size Bloat: A small fund buys Small Caps and wins. It becomes a 5-Star fund. Inflows flood in. Now it is a ₹30,000 Cr giant. It cannot buy small caps anymore. It buys large caps. Returns drop.
2. •Style Rotation: Value investing wins for 3 years. Then Growth investing wins. If your 5-Star fund is a "Value" fund, it will underperform in a "Growth" market.

Data Check: Look at the top 5 funds of 2015. Look at where they are in 2025. Most are now mediocre 3-Star funds.

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Part 3: The SPIVA Reality Check

S&P Indices Versus Active (SPIVA) report is the "Report Card" of fund managers. Latest India Scorecard:

• •Large Cap Funds: 62% failed to beat the Nifty 50 index over 10 years.
• •Mid/Small Cap Funds: Better, but the gap is closing.

If you pick a 5-Star Large Cap fund, you are paying 1.5% expense ratio for a manager who has a 62% chance of losing to a simple Index Fund.

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Part 4: What should you look at? (The Better Metrics)

Stop looking at Stars. Start looking at:

1. •

   Rolling Returns (Consistency):

   • •Don't ask "How much did it give in 5 years?" (Point-to-Point).
   • •Ask "How often did it beat the index in every 5-year period since 2010?"
   • •A fund that is consistently 4-Star is better than a fund that was 5-Star once and 1-Star later.
2. •

   Downside Protection (resilience):

   • •When the market fell 20% (Covid crash), did this fund fall 20% or 15%?
   • •A good manager protects capital.
3. •

   Fund Manager Tenure:

   • •"The fund has great returns!"
   • •But the manager who generated those returns left last month.
   • •Trap. You are betting on the jockey who already left the horse.

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Part 5: The Verdict (Decision Matrix)

Comparison:

✅ GREEN LIGHT (Buy IF)

1. •Rolling Returns > Index: Beat the benchmark 70% of the time.
2. •Low Expense Ratio: Direct Plans only.
3. •Stable Manager: Same manager for > 5 years.

❌ RED LIGHT (Avoid IF)

1. •"New" 5-Star Fund: A sudden jump in ranking (likely luck).
2. •Asset Size Explosion: A Small Cap fund that suddenly became ₹20,000 Cr+.
3. •Dividend Option: Always chose Growth.

The Final Word: Stars look good on hotels and generals. Not on Mutual Funds. Invest in a boring Index Fund or a consistent Flexi-Cap. Don't chase the "Hot Fund". By the time you buy it, it's already cooling down.