Why 5-Star Rating Does Not Guarantee You 5-Star Performance

The starting point for many mutual fund investors is looking at the ratings of the fund. They believe higher the ratings, higher would be the returns. Nevertheless, anyone tracking mutual funds closely knows how often these funds lose their coveted crown. Moreover, these are not universal ratings and these are always considered along with segment and category of the fund.  
Therefore, a five-star rated large-cap fund is not the same as a five-star rated mid-cap fund. Hence, in the current context, if a large cap fund gets 5-star rating, it is on the basis of its relative performance compared to other large cap funds. So, a small cap fund that might have outperformed a 5-star large cap fund may still have a rating of 3-star, because its entire category has performed better than large-cap funds.   
  
How do they rate  
Most of the mutual fund rating agencies rate funds on the basis of their historical returns adjusted for the risk. This is again compared to its category. Funds are then grouped into different tiers and top 10% may get 5-star rating followed by the next 22.5%, 35%, 22.5% and 10%, respectively, from 4-star to one star. 
Other important criterion for any fund to get rated is completion of certain number of years. For equity or hybrid fund, 3-year performance is required, and for a debt fund, there should be at least 18-month of performance track record.  

What you may miss if you follow ratings 
These ratings are purely based on statistics generated by the past performance of the funds, whether it is returns, risk or any other measure taken into account to arrive at the ratings. Therefore, a fund with higher star rating this quarter may lose its position in the next couple of quarters or in a year's time. This may be due to funds undergoing changes for various reasons, such as change in portfolio, change of fund manager etc.  
Hence, investors blindly following ratings may lose on two counts. First, the investor's higher rated fund might not have performed as it had in the past; and second, missing opportunity to invest in funds that might have performed during the period.  
Another area where rating does not help you in selecting the right fund is the new funds offers (NFO) and funds that have been in existence for less than three years since the rating agencies do not rate these funds.  
Therefore, as an investor, you should focus on drivers of fund’s future performance and not their ratings. The underlying stocks, fund manager’s track record and the segment to which the fund is dedicated (sector or market cap) will give you better sense of future returns and help you in selecting the right funds.