Building an all-season diversified portfolio across market caps

Market volatility is back with renewed vigour in recent times even after the finalisation of the India-US trade deal and removal of penal tariffs, a growth-oriented budget and strong domestic economic showing. A new war in West Asia involving several countries leading to severe crude oil supply and gas supply disruptions, relentless FPI selling and continuing AI-led disruptions on sectors such as software are taking a toll on the markets.

In the past 18 months from September 2024, the Nifty 50 TRI, Nifty Midcap 150 TRI and Nifty Small Cap 250 TRI have corrected about 6.6-17%. They have thus undergone price and time corrections. Much of the froth in the market has evaporated.

In such a correcting and volatile phase, it would help investors if they built a well-diversified portfolio with allocations to all market cap segments based on the prevailing conditions. Such a portfolio will be resilient and well-positioned to deliver steady risk-adjusted performance over the long term.

Common investor shortcomings

Investing across market caps by entering the most suited segment for a given macro situation is extremely challenging, more so for retail investors with limitations.

For example, investors who went by the spectacular performance (579% growth in AUM) of the midcap category over 2006-2017 and entered the segment in December 2017 would have been disappointed as the returns over the next year till December 2018 was -12.1%. Similarly, the small cap AUM saw a 1669% increase over December 2006 to December 2017. But the investors entered at the peak would have been hurt by a -19.2% category returns from December 2017 to December 2018.

Common investor shortcomings include an inability to withstand market volatility, panic selling during corrections, and missing opportunities. Another frequent pitfall is chasing funds, trends, or fads at their peak. Deviating from a carefully prescribed allocation across market caps or failing to rebalance regularly are additional mistakes. Finally, ignoring the costs and taxes associated with frequent portfolio churn can lead to a suboptimal investment experience.

Smart steps  

For building a holistic portfolio incorporating local and global parameters is critical to sound decision-making.

Factors such as inflation, Central Bank actions and outlook, geopolitical disruptions, fiscal and current account deficits, indicators such as PMI, IIP, vehicle and white goods sales etc. and supply chain modifications are all key to get an overall view of global and local equities.

Valuations play a critical role in deciding the suitability and extent of allocation of any particular market cap segment. Therefore, price earning, price to book and market cap to GDP ratios are to be keenly monitored.

Another metric that is useful is the relative strength index (RSI) differential, which is a key momentum indicator. It shows overbought or oversold securities and can be used as an added proxy for valuations.

Using these factors, the allocation to large, mid and small caps can be made systematically. Over the long term, the goal is to achieve diversification across market caps while incorporating a mix of counter-cyclical, growth, value, bottom-up, and contrarian investing styles.

For retail investors, a fund-of-funds spanning large, mid, small, flexi, multi, and focused schemes are ideal. Fund managers can make allocation decisions across these schemes without bias, and rebalance systematically based on rigorous research inputs and models.