Mutual funds are, to my mind, the best way to access the capital markets in India for most of us small investors. There are many mutual funds that have done a pretty good job of generating long term wealth. Knowing upfront or a priori which fund would do well in the long run is anybody’s guess. In fact data suggests that beating the wide market indices is more difficult for experienced fund managers.
Starting 1 Jan 2006 (15 years) through Dec 31 2020, (of course with survivor ship bias), we have 135 schemes (open ended, growth schemes) of all types (ELSS, mid-cap, sector funds, value funds etc.). Of these 135 funds, only 32 funds beat the NiftyNext50TRI index and 69 funds beat the NIFTY50TRI Index. That means beating a mid-cap index like NiftyNext50TRI takes you to 77 percentile of funds. Beating the Nifty50TRI is similar to tossing a coin.
Knowing a priori what would have been potential future winners is clearly tough. What Given this, how does one go about selecting a mutual fund. Is there such a thing called best fund? Are we all to do only index investing?
I would suggest that investing into both the leading indices based mutual funds (NiftyNext50 and Nifty50) is the best way for most investors. But, if you happen to be a person willing to do some legwork, I propose a method.
This proposal is not unique. The idea to check was based on a blog As many of you know, value and momentum are good ways to invest into individual stocks. These are considered factors that affect a portfolio’s behavior. The blog suggests that even within anomalies (all factor investing) , valuation and momentum matters. If you have combination of cheap anomalies and anomalies exhibiting momentum, you may be able to time the anomalies. You could move in and out of factors based on the performance. This is incredible to know and hopefully, it piqued interest in me to explore the feasibility of doing a similar study in India.
Assume that all mutual funds are doing an honest job of sticking to a core philosophy. It is possible to map a fund’s stock selection criterion to an academic identified factor. If we could see a mutual fund exhibit value and momentum in all the mutual funds, we pick the best fund. Voila! we have a possible strategy at play.
The setup: All equity mutual funds available for investment as on Dec 31 of each calender year. In order to avoid look ahead bias, we shall assume that by Dec 31, the November month fund factsheet are available. We compute annual mutual fund return based on Jan 1 through Dec 31 period for momentum score. We select the top decile of cheapest mutual funds by PE ratio AND Momentum scores (highest return mutual funds for past 12 months). We invest equally into these schemes for 12 months and rebalance again on Dec 31 of next calender year.
In the chart, VMF stands for “Value and Momentum in Funds” i.e our current investment strategy. You can see that the blue line (except for initial months of 2004), is almost always above the two index lines and in fact during the 2008 fall actually fell less than NiftyNext50TRI. Despite index corrections in 2011/12 period, the fund actually does not correct and does better than both.
Similarly, comparing SIP, you can see a clearly beating both the indices again. During this period, the VMF strategy actually ends up in the top 5% mutual funds both in terms of actual NAV growth as well as SIP returns.
The key draw back of this method is the continuous rotation in and out of mutual funds every year. Prior to 2018, this actually had no taxation implication. Since then, with LTCG being taxed, this does create a problem in terms of comparison. Assuming a hypothetical 10% LTCG paid every year from the fund would have resulted in the following comparison.
As can be seen, clearly, taxes have reduced the out performance but is still pretty good compared to the indices.
Conclusion
Value and Momentum can exist in mutual funds as well. This can be a pretty good and easy strategy to implement in our individual portfolios. In the next blog post, I shall capture on the tools to select mutual funds based on these ideas. I will also provide an alternate and easier strategy to implement.
Jan 2021 Update
What does the strategy suggest we invest into at end of January 2021? Well, it suggests in equal measure: ICICI Pru Commodities fund, Tata Resources & Energy fund, SBI Technology Opp fund and ICICI Pru Focused Equity fund. Obviously, we shall select the growth options with Direct plans to reduce taxation and expense costs respectively.
This is not a recommendation but an observation. I am not an advisor for anything