Can mid & small caps reduce portfolio risk?

The core objective of a risk-averse investor is often to earn reasonable returns while keeping risk low. Many are comfortable with slightly lower returns if their portfolio remains stable during uncertain times, prioritising capital protection over high gains.

One key way to measure risk is through standard deviation (volatility), which shows how much returns have fluctuated in the past. For instance, the Nifty 50 had a volatility of around 13.5% indicating fluctuations within approximately ±13.5% during that period. There’s no ideal volatility number—it depends on each investor’s risk tolerance.

For perspective, the Nifty India Defence Index had volatility over 32% during the same period, still saw investor participation. This shows that volatility alone doesn’t determine a fund’s quality, but it remains crucial for those seeking consistency and downside protection.

Index volatility numbers

What happens if an investor, who already holds a core portfolio in large caps like the Nifty 50, wants to get some exposure to mid and small caps — while aiming to manage overall portfolio risk? The Nifty 500 Index includes the top 500 listed companies in India across large, mid, and small cap segments. Roughly, the index has about 70% weight in large caps, 20% in mid-caps, and 10% in small caps.

In shorter time periods, the volatility or standard deviation of the Nifty 500 has been higher than that of the Nifty 50. For instance, over the last one year, the Nifty 500 had a volatility of around 14.9%, which is 1.4% higher than the Nifty 50. However, over longer timeframes — say, 7 years and beyond — the situation actually reverses.

Over the last 15 years, the Nifty 500 has shown slightly lower volatility than the Nifty 50. While Nifty 50’s annualised volatility stands at 16.6%, the Nifty 500 comes in at 16.3%t. The difference may seem small, but it is still notable considering the broader index includes mid and small cap stocks.

Correlation effect

When investors think of mid and small caps, the common belief is that they increase portfolio risk. However, over longer periods, historical data shows this hasn’t always been true. It’s not just diversification at work – correlation also plays a big role in portfolio behaviour.

Nifty 50 stocks often move in tandem, especially during sharp market swings. Over the past 20 years, the correlation between Nifty 50 and Nifty Next 50 has been about 0.87, meaning they largely rise and fall together.

As we move to smaller segments, this correlation has historically tended to decline. Mid-caps show a correlation of around 0.84 with Nifty 50, and small caps drop further to 0.77. Microcaps, which fall outside the Nifty 500, typically have even lower correlation, as they move more independently and are influenced by stock- or sector-specific factors.

Since all stocks don’t move in the same direction or intensity, their combined effect helps in creating balance. 

Risk in crisis periods

Panic-driven markets tend to spike volatility as investors rush to buy or sell at distorted prices. During such periods, the Nifty 50 often reacts more sharply than the broader Nifty 500.

Historically, the Nifty 50 has shown higher volatility during extreme crises.This is because Nifty 50 companies are more globally connected and heavily held by foreign investors, making them more sensitive to global shocks and capital outflows.

However, in relatively calm phases, the trend sometimes reverses. The Nifty 500 can show higher volatility, driven by greater investor interest in mid and small caps. As market sentiment improves, investors take on more risk and diversify into the broader market, increasing trading volumes and price movements in these segments.

Sector tilt

The sectors an index is exposed to can significantly impact its overall volatility. Some sectors are known to be aggressive and highly sensitive to market cycles, while others are more defensive and stable in nature.

The Nifty 50 has a higher weight in financial services, energy, and information technology, which are among the most volatile sectors based on 10-year historical data. Each of these sectors has had an annualised volatility of around 21%. On the other hand, the index is underweight in healthcare, services, and consumer discretionary, all of which have shown relatively lower volatility, ranging between 16-18%. This sectoral skew contributes to the higher volatility of the Nifty 50 over the long term.

Meanwhile, the broader Nifty 500 spreads its exposure across a wider base, including sectors that offer more resilience during market corrections.

Recent trends

Although historical data suggests that the Nifty 500 has exhibited lower volatility than the Nifty 50 over the long term, it’s important to acknowledge the recent shift in trend. In the last few years, the volatility of the Nifty 500 — especially over shorter timeframes — has started to rise noticeably.

This is not unusual in a fast-growing economy like India. In high growth or emerging markets, capital flows tend to chase growth-oriented businesses, many of which lie outside the mature large cap space. As a result, mid and small cap stocks — which form a significant portion of the Nifty 500 — have historically experienced sharp price movements when there is heightened investor activity or increased trading volumes.

Conclusion

Volatility is not driven by a single factor. It is influenced by a combination of elements such as index concentration, sector exposure, foreign investor participation, correlation among stocks, and broader macroeconomic cycles.

While the Nifty 50 may appear more stable on the surface due to its focus on large caps, it often carries higher concentration risk, global exposure, and experienced sharper swings during crises. In contrast, the Nifty 500 — though it includes smaller companies — offers better sectoral balance, lower correlation across components, and a wider investor base, which has helped dampen volatility over time.

(The writer is Head of Research, Passive Business, Motilal Oswal AMC)