In our previous blog, we were inspired by blog. We notice that valuation and momentum in an anomaly matters. This got me thinking as to what is special of value and momentum. Apart from the fact that these are the most popular factors, there is no real reason that anomalies exhibit other factor tendencies. With this basic though process, I approached the problem of selecting a mutual fund through the three most common factor views : Value, Momentum, Quality.
For Value, we shall look at valuation at end of Nov of each calendar year. (available through the Fact sheet made available in December).
For Momentum, we shall use the prior six month returns.
Quality: Given a fund’s fact-sheet, this is difficult to actually compute. We shall use a very crude approximation to arrive at this.
We note P/E = Market Capitalization / Net profit
P/B = Market Capitalization / Book Value.
If we use a very crude but decent approximation of Book value = Shareholder’s equity, we can compute ROE = (P/B) / (P/E) i.e we divide the price to book ration by the price to earnings ratio to compute the ROE. Again, this is only an approximation.
We use all open ended, growth mutual fund schemes available on said date for this back test (WARNING: has survivor-ship bias). We include sector funds, thematic funds, index funds and even foreign equity only funds. We avoid ELSS and ETF due to the requirements being different.
At the end of each calendar, based on the November monthly fact-sheet, we rank all mutual fund schemes based on P/E, MOM and ROE. We remove the bottom 70% of schemes in each rank. We invest equally into the remaining funds and hold for a year.
The magnitude of out-performance is clearly visible. In fact take any period of 5,10,15 years, the strategy always beats the index as well as is in the top 5-10 schemes in every tenure of comparison/observation. What is very important to note that apart from the period during March 2020 (covid crash when everything inluding T-bills, USA stocks, Gold, Indian stocks collapsed), there are almost no periods with more than 20% falls. Interestingly for the period of Dec 2007, in the midst of the Global Financial Crisis, the strategy selected NO scheme. Basically, there were stocks which were cheap and exhibiting momentum but were not quality stocks similarly, whatever was good quality was either not exhibiting momentum or was not cheap. For the period in 2008, the above assumes investment into liquid funds. Interestingly, for the periods in 2018.2019, it turns out the the index (Nifty50, Sensex) were respectively, better suited for investment than most active funds. All this means we have a much more stable strategy, with less draw downs with decent strategy alpha.
I shall myself be using this method going forward (whenever I do not want to invest into direct stocks).
Update as of Jan 31 2021.
As of the latest data, the best funds are SBI Technology Opp Fund, Aditya Birla Sunlife Digital India Fund, Tata Digital India Fund, Franklin Build India, Franklin India Focused Equity
Hi Sharat, these are great findings, the returns especially seem unbelievable. May I know from where you got the historical p/e and p/b ratios of mutual funds?