Election hurdle for sentiment

The conventional wisdom is that largecaps are less ‘risky’ even though they give lower returns than smallcaps/midcaps. Most direct investors accept the risk and look for smallcaps/midcaps in the hopes of earning higher returns. Aggressive active funds also seek multicap exposure for the same reasons.


In the Indian context, we can compare the Nifty, which tracks only largecaps, to the NSE 500, which offers broad multi-cap coverage including many midcaps and some smallcaps.  The Nifty has a 10-year compounded annual growth rate (CAGR) of 9.5 per cent since July 2008, and it has returned 6.8 per cent in the past 12 months. The NSE 500 has a 10-year CAGR of 10.4 per cent, and it has returned 5.5 per cent in the last 12 months. 


The NSE 500 has more volatility, which is one measure of risk.  For a long-term investor, the key returns would be monthly or longer. In an average month, the Nifty moves 4.3 per cent (absolute change, neglecting direction) while the NSE 500 moves 4.5 per cent.


Taking 12-month rolling returns over the last 120 months is one way to judge returns as they accrue to investors using SIPs. There are 109 rolling 12-month returns. The Nifty's maximum drawdown was minus 21 per cent and the maximum 12-month gain was 81 per cent. The NSE 500's maximum rolling drawdown was 23 per cent and the maximum rise was 97 per cent. The Nifty has 23 negative returns in that 109 rolling sequence while the NSE 500 had 25 negative returns.


The average rolling return is 13.6 per cent for the Nifty and 15.5 per cent for the NSE 500. This is what you're likely to get if you hold for at least a year. The NSE 500 has a higher standard deviation of 23.5 versus the Nifty's standard deviation of 20, which means the returns will be much more variable for NSE 500. 


So the NSE 500 is indeed both more risky and also likely to give better returns. The correlation between rolling returns is 0.99, which means the indices move in the same direction almost always. Even the monthly returns have 0.98 correlation, which is very strong.


The Nifty is a highly liquid index. It is possible to mirror Nifty by buying exchange-traded funds/index funds and also the funds, which have betas close to 1. You can also hedge any Nifty positions by using derivatives. (This is not necessarily a good idea for long-term investors but it can be done).


The NSE 500 doesn't exist in terms of derivatives. Few mutual funds use it as a benchmark.  If you wish to capture a performance similar to NSE 500, you must look at multi-cap funds, which cover the same equity territory. You also have to accept higher levels of risk.


Given all that, is it worth it for an investor to try to track NSE 500 and attempt to replicate its performance? The answer is, yes. Over long timeframes, the chances of losing money in any given 12-month period is roughly the same for both indices. But the chances of excess return from NSE 500 oriented portfolios seems to be higher. 


Compounding over 10-15 years, an excess return of 1 per cent CAGR is considerable and the rolling returns indicate that investors using SIPs can hope for more. Multi-cap funds, which come close to mirroring the NSE 500, seem to give an excess return of about that much over large cap funds.


So the prescription for an active NSE 500 investor would be to either take SIPs in mutual funds, or slowly build positions in chosen small-caps and mid-caps. Even if the market is going up, take SIPs rather than invest lump sums. If you're a direct investor, increase stakes slowly, rather than take large positions in stocks at one go. This would cut down some of the risks caused by volatility.


Since there's high correlation, Nifty derivatives can also be used to hedge an NSE 500-oriented portfolio.  As mentioned above, this doesn't make sense for a long-term investor. But it's possible. As noted above, the past 12 months have seen under-performance from the NSE 500 compared to the Nifty.


That underperformance could continue for quite a while, given political uncertainty and inflationary conditions. Market sentiment will not be consistently strong until the next Lok Sabha elections. If market conditions are bearish, smallcaps and midcaps will lose more than largecaps. But a downturn is an ideal time to start building a multi-cap portfolio.