Last Updated on December 29, 2021 at 12:11 pm
It is well known that small cap stocks and therefore small cap mutual funds are high-risk instruments with potential high return. The small cap investor may feel like riding a roller coaster on Red bull – stupendous gains or losses over a short period, followed by years of no returns. So it is a natural choice to periodically book profit from a small cap mutual fund (or stock) and re-enter when the market is “down” as mentioned in the SBI Small Cap Fund Review. How effective is this strategy? Let us find out via a back-test.
Before we begin a disclaimer and warning is necessary. The following is to be treated as investment research based on past data unrepresentative of practical implementation and is not investment advice. They do not factor in behavioural/emotional aspects associated with investing. If you do not know how to understand a backtest result, evaluate its disadvantages, then please, please DO NOT play with your money using market timing.
I have shown only one back result over 13 years and 61 results over 8 years. Results will vary if we consider more periods (but data is unavailable). The purpose of this post is to introduce an idea of tactical asset allocation between components of an equity portfolio. There can be multiple ways to test this with better results. No claim has been made and should be made that tactical asset allocation (TAA) is superior to systematic investing.
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The above graph illustrates how volatile the small cap index can be. After 14 years, the small cap index is lower than the large cap index in spite of periodic surges. Hence the need for periodic profit booking and re-entry
Details of the Small cap fund TAA vs systematic investing backtest
We shall only consider a change of asset allocation within an equity portfolio. It is assumed that the investor has adequate fixed-income investments elsewhere. The equity portfolio shall consist of Nifty 50 (called large cap from now on) and Nifty Small Cap 250 (called small cap from now on) Indices. We avoid active mutual funds to prevent any selection bias.
Details of study are identical to the previously published Market Timing With Ten Month Moving Average: Tactical Asset Allocation Backtest Part 2. Details are reproduced for completeness. Readers can refer to this study for more details on the history associated with the ten months moving average and can also consult the full archive of Tactical Asset Allocation studies.
1: systematic investing into a portfolio of 50% small cap and 50% large cap. The portfolio will be rebalanced once a year. To account for exit loads and tax associated with this, the final portfolio amount will be reduced by 4%.
2: Tactical investing with the following rules.
Check small cap index once a month (at the start)
If current price > 10MMA (last ten month price average): Invest Rs. 2000 that month in small cap. Also, sell large cap and invest into small cap.
The large cap sale and small cap investment are considered being done on the same day (which is impossible unless they are held as ETFs).
If current price < 10MMA: Invest Rs. 2000 that month in large cap. Also, sell small cap and invest into large cap.
The final tactical portfolio is reduced by 20% (this is 5 times the amount assumed for the systematic portfolio as the average no of trades in 10Y is about 5 in previous backtests). This 20% accounts for exit loads of equity and fixed income and tax associated with equity. Remember equity was taxed like a debt fund before 2004 and will be again taxed from the current FY.
Profit Booking from Small Cap Mutual Funds: Result over 13 years
We consider a single back-test window of 13 years from 1st Feb 2006 to 1st Feb 2019.
We can see that the tactical portfolio has outperformed the systematic approach although there is not much benefit in terms of risk reduction. The stats for the back-test are given below.
| Start Date | 01-02-2006 |
| End Data | 01-02-2019 |
| XIRR Systematic | 10.50% |
| XIRR Tactical | 12.75% |
| Value systematic | 6.4 L |
| Value Tactical | 7.6 L |
| Max Drawdown Systematic | -48.9% |
| Max Drawdown Tactical | -49.2% |
| No of Small cap Sell offs (completely) | 8 |
| Months of no investing in small caps | 79 |
| Maximum period of no investment in small caps | 14 |
| Stdev Normal | 29.2% |
| Stdev Tactical | 28.7% |
| Systematic no of months under water | 64 |
| tactical no of months under water | 67 |
| Systematic max no of cont months under water | 19 |
| tactical max no of cont months under water | 22 |
Max drawdown refers to the extent of a fall from a portfolio maximum. This is similar for both strategies. So it the standard deviation: average deviations of monthly portfolio returns from its average (measure of volatility). See for example:
Under water here means the portfolio has a value lower than its past maximum. The no of such instances and the months where the portfolio was continuously underwater are also measured. The months under water are shown in the box. See: Market Timing With Ten Month Moving Average for details.
I want to make it clear that this is just one backtest run and results could vary if we (could) do for more.
Backtest results: 8 years
The strategy was backtested over 8 years just to get more data points although this is not practical.
We compare the returns in the top panel and max drawdown in the bottom panel. Sometimes the systematic portfolio does better in terms of returns and sometimes the tactical portfolio. In terms of max drawdown, the tactical portfolio has a higher drawn down most of the time. This means it falls more from the peak. At least over 8 years that is disappointing.
Summary
Profit booking from small caps makes sense intuitively. We can consider absolute gains in the past quarter, 6 months or year and book profit to either large caps or to fixed income and re-enter when there is a significant correction (eg. small cap have fallen by more than 20% in the last year).
The single backtest over a 13 year window supports this but more data and more strategy variations are necessary for conclusive results. The backtest over 8 years suggests that sometimes this technique can be fruitful although with higher risk. Unfortunately we cannot predict when it will work in future. We shall try variations with Nifty Next 50 and see where that takes us.
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