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SmallCap Investment Strategy

Hypothesis

Divergences between returns of large cap and small cap indices, viz. NIFTY 50 and NIFTY SmallCap 250 can be utilised to generate above-benchmark returns

Execution

We use a simple method to decide when to invest in or withdraw from a NIFTY SmallCap 250 Index Fund. Here's how it works: We look at the relative returns of the NIFTY SmallCap 250 index compared to the NIFTY 50 index; this comparison is called the "Ratio." We then check how much this Ratio typically varies using a statistical measure called "standard deviation" (σ).

Investment Rules: Invest in / withdraw from a NIFTY SmallCap 250 index Fund on the middle and end of every month based on following rules:
  • Moderately High Ratio (+1σ to +2σ): If the Ratio is slightly above average but not extremely high, we invest ₹X (this can be any amount that you plan to invest).
  • Very High Ratio (≥ +2σ): If the Ratio is much higher than usual, we withdraw ₹X*6.
  • Average Ratio (-1σ to +1σ): If the Ratio is close to average, we invest ₹X*3.
  • Moderately Low Ratio (-2σ to -1σ): If the Ratio is below average, we invest ₹X*5.
  • Very Low Ratio (≤ -2σ): If the Ratio is much lower than usual, we invest ₹X*6.

Why These Rules?
  • Buying Low: When the Ratio is low, it means the SmallCap Index hasn't performed as well compared to the NIFTY 50, so we invest more, expecting it to rise.
  • Selling High: When the Ratio is high, it means the SmallCap Index has outperformed the NIFTY 50, so we either scale down our investment or withdraw some money, anticipating it might fall.

    • By following these simple rules, we aim to buy more units of the NIFTY SmallCap 250 Index Funds when they are cheaper and sell when they are more expensive, potentially increasing our returns over time. Calculate the ratio of NIFTY SmallCap 250 TRI returns to NIFTY 50 TRI returns, and its standard deviations (σ) based on historical data (refer ratio chart)

    Note: Chart is updated daily

Ratio
± 1 σ
± 2 σ
± 3 σ

Returns

SIP in NIFTY 50
SIP in NIFTY SmallCap 250
SmallCap Investment Strategy
*Returns are annualised using XIRR formula

The chart compares the returns of this strategy against fortnightly Systematic Investment Plans (SIPs) of ₹X in NIFTY SmallCap 250 TRI and NIFTY 50 TRI.

Above-benchmark returns are generated in the long term by using this strategy to adjust the timing and magnitude of investment / withdrawal from a NIFTY SmallCap 250 Index Fund. Specifically, the returns significantly exceed the benchmark over 7-year, 10-year, and 12-year periods. This can be attributed to the fact that the cycle of the relative [under/over]-performance of smallcaps over large caps plays out over a longer time period.

Recommended reads

SmallCap Investment Strategy: A Comprehensive Guide
CAGR vs IRR: Which One Really Measures Your Investment Success?