Choosing the Right ELSS Fund

While India hasn’t been caught up as much in the move from active to passive other than on Twitter., the truth is that such a day is not far away given better education of the client since data that shows how few funds are able to beat the benchmark they track.

But while the odds of an active Mutual fund beating the benchmarks today stands at less than a coin toss, there are funds that have beaten the benchmark even on a 10 year stretch.  The big question though is whether we can identify such funds other than in hindsight.

Most mutual fund rankings that exist today are heavily tilted towards the recent performance of the fund. If the fund is performing strongly vs its peers, it gains a higher rank and vice versa. The problem with such rankings is the volatility of the ranks themselves. What is a 5 Star rated fund today can in a few months from now be a 3 Star rated fund. 

Randolph B. Cohen, Joshua D. Coval and Luboš Pástor wrote a paper titled Judging Fund Managers by the Company They Keep. While this paper came out in February 2003, it was only recently that I was able to read the same. I am not aware of any fund site that uses similar methodology to rank but the thought process seemed to have legs.

Investing in ELSS funds to save tax may not be required going forward for those who don’t wish to take advantage of the exemptions offered. While the tax advantage may go away, the bigger advantage of investing in a ELSS fund is that thanks to the lock-in, scope of one panicking and exiting the fund at the wrong juncture is minimized. I recently wrote a post around that though process – ELSS as a Nudge for Long Term Investing

Personally ELSS is my choice when it comes to tax saving instruments and every year I keep experimenting with strategies on which fund to pick. While it’s tough if not impossible to predict which fund shall do well over the next three years, I believe that it makes sense to give it a try than invest randomly even though the results of either endeavor maybe the same.

This year, I decided to modify and apply the strategy of selecting the fund based on the paper I have quoted above. With every fund house having an ELSS fund to attract such investors, today we have a choice of around 38 funds to choose from. 

18 Funds with Assets under management of greater than 1000 Crore have cornered 96% of the corpus (of approximately 98K Crores). I decided to take a deeper look at only these funds with two exceptions being Parag Parikh and Quantum. 

The method I choose to rank has two parts. On the first run, I decided to weigh their portfolios based on the strength of the portfolio stocks multiplied by its weight. The strength of the stocks was determined by their long term Momentum Score. 

A stock such as Bajaj Finance has very strong momentum while a stock such as Lupin scores very lowly on long term momentum. By multiplying the score by the weights, I am trying to reward funds that have strong stocks as their top picks versus funds that may hold the same stocks but have weights that are much lower.

While a high Momentum Score is good, what we also need to look at is how unique or otherwise the portfolio is. One way to go about doing this is find the covariances of the managers portfolio versus other portfolios. 

In other words, the focus here is to pick a portfolio that consists of good quality stocks that have generated strong risk adjusted return in the past and one that is as unique as possible compared to the alternative portfolios in existence.

Do note that when we talk about portfolios, we are talking about the current portfolio which is bound to change over the coming years. But if the fund manager has a great portfolio today and one that is unique, he would rank higher versus a portfolio of  stocks that have given poor growth and one that is not unique either.

To give an example, Pidilite Industries is a great company with a delightful product and more delightful advertising (in the past at least). Yet, only one fund has an allocation to this stock among the 20 we are scrutinizing. On the other end of the spectrum, you have Quantum which is the only fund to hold Yes Bank while SBI is the only fund that continues to hold Manpasand. 

By combining the scores, here is the final list of funds and their relative rank. It should be interesting to see how they fare at the end of 3 years from now.

Do note that Prediction is Impossible. Idea of having a method is any day better than making a  random choice. Past Performance of a fund may not be indicative of its future performance, but the Past Performance does provide data points which could be useful and the above analysis is one such attempt.

My past fund choices

2017: Axis Long Term Equity Fund

2018: Invesco India Tax Plan 

2019: Canara Robeco Equity Tax Saver

Some Trivia: 

Of the 20 funds, 19 of them have ICICI Bank. PPFAS is the odd man out. 

Across the 20 funds, they own around 350 Stocks with 185 stocks finding a space in only one fund.

IDFC Tax Advantage fund has the highest number of stocks in the portfolio {73 Stocks} while PPFAS has the smallest portfolio with only 20 stocks finding a space.