The Impact of Universe Selection on Momentum Portfolio Returns in the Indian Equity Market
In the realm of momentum investing, a critical yet often overlooked factor is the choice of universe from which stocks are selected. Universe selected has a great bearing on the returns made by the portfolio. It also affect several other parameters related to risk. Therefore a detailed understanding of different universes, will help different investors (conservative to risk takers) decide on the exact universe based on which their portfolio has to be constructed.
To this end, we use a study An Examination of Number of Holdings and Universe Size in Momentum Strategies: Evidence from India by Rajan Raju (2023). This study delves into the Indian equity market to investigate how different stock universes affect portfolio-level returns in momentum strategies. The research aims to shed light on a fundamental question: Does the type of universe significantly influence the performance of momentum portfolios?
Methodological considerations of the study
1. Universe Selection: Six distinct universes are considered — Top 200, 325, 500, 625, 750 stocks by market capitalization, and a Mid-Small Cap 400 (MSC400) universe.
2. Portfolio Construction: For each universe, 16 portfolios are created, varying in the number of holdings from 5 to 80 stocks in increments of 5. This approach results in 96 unique portfolios examined each month.
3. Momentum Calculation: The study uses the standard academic construction of momentum, calculated as the total returns over the past 12 months, excluding the most recent month.
4. Weighting Schemes: Both equal-weighted and market-cap weighted portfolios are analyzed to account for potential biases and reflect different investment approaches.
5. Time Period: The study covers the period from October 2004 to April 2023, providing a substantial dataset spanning various market conditions.
6. Performance Metrics: Key metrics examined include annualized returns, standard deviation, Sharpe ratio, and maximum drawdown characteristics.
Analysis and Findings
Based on figure 1
· Nifty 200 Universe has an almost an equal representation from both the large cap and mid cap which is around 50%.
· Nifty 500 Universe things start getting interesting where a majority of the representation comes from the small cap universe and a small minority will be coming from both the mid and large cap together. To put it in numbers, around 70% is from the small cap universe and remaining is from both mid and large caps.
· In the Nifty 750 Universe about 80% of the stocks come from micro and small caps and an even smaller representation is from large and mid cap spaces.
This is because momentum calculation is based on return and small the cap, bigger the returns.
However there are additional parameters apart from just returns to understand the performance of different universes of stocks while building momentum portfolios. Overall we have 4 parameters to comprehend the behaviour of each universe and those are as follows:
1. Returns
2. Risk (measured by both standard deviation and sharpe ratio)
3. Maximum Drawdown and
4. Drawdown days
Let us look at each of them individually and compare across universes with the following table:
Returns
The NIFTY 750 universe produced the highest returns at 35.12% followed by the Nifty 635, NIFTY 500, NIFTY 325 and lastly the NIFTY 200 which produced the least returns at 24.52%. This suggests that expanding the universe to include mid and small-cap stocks significantly enhances momentum returns in the Indian market.
Risk (measured by Std. Dev and Shapre Ratio)
Risk generally increased with the size of the universe. The Top 200 universe had the lowest annual standard deviation at 25.84%, while the Top 750 universe had the highest at 31.91%. However understanding the risks in comparision to return gives us a clearly understanding of the risk to reward ratios which is measured by Sharpe ratio.
Considering that a Sharpe Ratio of 1 or more is an ideal case scenario, table indicates that Sharpe ratios are more favourable in the NIFTY 750 universe with values of 0.91 which is way closer to 1 than the Nifty 200 universe is at 0.71. Even the risk to reward indicate that the Nifty 750 universe has more favourable risk to reward ratios.
Max Drawdown
However, the maximum draw down or the maximum plummet is experienced as the universes keep getting bigger. That is Nifty 200 has the lowest maximum possibility for drawdowns at 285 % whereas, the Nifty 750 universe can see drawdowns as low as 45%.
Drawdown Days
It is established by now that the markets are not linear and experience corrections from time to time. Therefore it is important to understand the kind of recovery which is being made from such a draw down and the time that is taken for such recovery.
These parameters are extremely crucial as a conservative investor maynot like the kind of deep corrections and the recovery periods unlike a risky investor who prefers to take a risk despite the deep corrections give the returns that are in question.
The table above indicates clearly that smaller the universe, quicker it is for the portfolio to bounce back from a deep correction. Nifty 200 universe hardly takes 214 days or less than a year’s time to bounce back from the correction whereas the 750 universe requires a solid 3 years or 914 days to recover indicating the excruciatingly long period one needs to hold their stocks should there be a drawdown of a large magnitude.
While these are the statistics with respect to major universes, the study also puts forth another universe consisting purely mid and small caps also called as the MidSmallCap 400 (MSC 400).
The results of this Universe are rather encouraging with
· Returns being at 34% which is way ahead of all the universes except and 750 and not very far off from 750 which has slightly over 35% in returns.
· Even in risk to rearward parameter, the MSC400 universe showed a relatively moderate risk level (30.44%), Sharpe ratio of 0.93 (highest among all) considering its high returns, indicating a potentially superior risk-return trade-off.
· Maximum drawdown figures are also at a low of 29.4% which is a close match to the 200 universe (lowest drawdowns with 28.5%), which is a positive marker for this universe.
· However, MSC 400 does not complete with the Nifty 200 universe in terms of recovery from the drawdown with it taking 670 days to recover and 200 universe taking on 214 days (again least of all categories).
These findings suggest that the MSC400 universe, in particular, seems to offer an attractive balance of high returns, moderate risk, if one can hold on to the number of recovery days from the drawdowns.
In conclusion,
Returns increase as we go down the Market Caps but higher returns are associated with higher risk. Therefore, of all the universes, the MSC 400 provides the best risk reward ratios with seemingly tolerable maximum drawdowns.
Watch the full video on youtube here: https://youtu.be/vPGxmBeBQTA
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**Disclaimer:** We are not SEBI registered advisors. Any content shared on or through our digital media channels is for information and education purposes only and should not be treated as investment or trading advice. Please do your own analysis or take independent professional financial advice before making any investments based on your own personal circumstances. Investment in securities is subject to market risks; please carry out your due diligence before investing. And last but not least, past performance is not indicative of future returns.
