Build core portfolio around large cap ETFs with an aim to beat volatility

In the three months ended April 27, 2020, Nifty 50 TRI and Nifty Next 50 TRI fell just 23% and 19%, respectively, compared with 29-37% by mid-caps and small caps.

The equity markets have taken a severe beating amid the Covid-19 pandemic and concerns about the potential economic damage from the lockdowns. Despite the market volatility, large companies with stable businesses, significant market presence, strong cash flows and steady dividend payouts, among other parameters, continue to fare better. Their stocks have performed better than the broad market and the stocks in the lower market capitalisation.

Read on to find out more about large cap stocks for better investment opportunities during market volatility and downturn and how exchange traded funds (ETFs) in this space may be a suitable ally for investors in such trying times.

Why large caps?

Large caps are companies with stable businesses and given their size and track record, these companies are relatively less volatile during market downturns and are usually good compounders in the long term. Run by experienced management, large caps are at the matured life cycle stage compared with mid- and small-sized companies, which are in the middle or early life cycle stage with a strong growth potential, but more vulnerable to a business or economic downturn.

This was witnessed recently when the Covid-19 pandemic rattled the equity markets. Large caps, represented by Nifty 50 TRI and also Nifty Next 50 TRI (highlighted in black and orange in Chart 1), have fallen less than the small and mid-caps (Nifty Midcap 100 TRI and Nifty Small cap 100 TRI). Thus during times of volatility, large caps has performed better than midcaps and small caps.

In the three months ended April 27, 2020, Nifty 50 TRI and Nifty Next 50 TRI fell just 23% and 19%, respectively, compared with 29-37% by mid-caps and small caps.

Why Nifty 50 and Nifty Next 50?

Now that it is clear that large cap stocks are an active opportunity for investors for their core portfolio, we Nifty 50 and Nifty Next 50 encompass the entire large cap universe in the domestic stock market. Nifty 50 is the older and more tracked index between the two and comprises the top 50 large cap stocks in the country, while Nifty Next 50 index represents the next 50 companies in the large cap universe in the market capitalisation order.

Decent performance has also come with low volatility which is one of our primary factor of investing in these volatile times. Volatility, measured by standard deviation, was at 13% and 15%, respectively, compared with 14% for large cap funds during the three-years holding period. (See chart 4)Volatility tends to reduce over the long-term horizon, as evident in the chart.

The market phase analysis reveals that the performance of Nifty 50 has been in line with or below large cap funds across most bull and bear periods. Further, Nifty Next 50 has fallen less than the large cap funds during the recent Covid-19 crisis and also during the Chinese slowdown in 2016. Nifty Next 50 has rebounded well compared with large cap funds post subprime and euro zone crises.

Nifty closing versus its intraday high and low closing value

Notes: Data from January 1 to April 30, 2020

High represents the variation in absolute value of the high point of the index intraday versus that day’s closing value

Low represents the variation in absolute value of the low point of the index intraday versus that day’s closing value

Source: National Stock Exchange of India

Summing up

Inclusion of both Nifty 50 and Nifty Next 50 ETFs can be good value additions to the active investment portfolios both in terms of core strategic portfolio and tactical investments in the current volatile market scenario. However, due diligence of schemes in terms of expense ratio, tracking error (a measure of how closely the index fund’s returns match its benchmark returns), and track record of the fund house, is a must. Investors should not panic when unprecedented events like the Covid- 19 pandemic batter the stock market; instead, they should hold on to the investments for the long term.

It is always advisable to consult your financial advisor before investing.

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