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Of late, equity markets have turned quite volatile and foreign institutional investors are exiting and geopolitical tensions especially in the Middle East are escalating. So, in such a scenario, what's your outlook on the equity market and specifically how comfortable are you with the valuations around equity?
Most of the sell-off in the last two months has been driven by the foreign portfolio investors. It has affected the large caps more because FPIs hold a larger proportion of large caps. While Nifty 50 was down by 8% by the end of the first week of December, small cap index was down 3%. This is atypical as small-caps are usually sold off first due to be being riskier, so this drawdown we have seen is flow-driven.
Indices like Nifty 50 or Nifty 100 appear more reasonable compared to the whole breadth of the market. For example, the median P/E of the 250th stock in the Nifty 500 or BSE 500 was around 50-53 times recently, much higher than what you'd expect from a few years ago. The headline index valuation hides more than it reveals because it is weighted towards larger companies with more reasonable valuations.
A lot of people feel that small cap markets have reached their full potential in terms of valuation. What’s your view on this?
Valuation is all about expectations. Markets are always forward-looking, pricing in what they think profitability and growth will look like 10 or 15 years down the line. If those future cash flows and growth play out as expected, then there’s no reason to say today’s valuations are frothy. But if that growth doesn’t happen, then in hindsight, you could say the valuations were frothy. It’s hard to judge in advance whether valuations are too high or not.
So, what's your opinion on the current small cap valuation?
The P/E of the small cap 100 is about one standard deviation above its 6-7 year average but still not excessively stretched. While some smaller companies have untested business models, if their growth meets expectations, current valuations could be justified.
Over the past 4-5 years, the small cap space has expanded due to private issuances and interesting business models in sectors like electronics manufacturing (benefiting from government incentives) and niche areas like diagnostics and healthcare, which have strong growth potential. If these companies can deliver growth and strong cash flow over the next 10-15 years, supported by industry trends and management execution, current valuations are reasonable. However, there are still areas with stretched valuations.
Of all the smart beta factors, which factor is looking promising in today’s market?
Momentum has been the best performing factor. The markets have just been going up over the last 15 years and we have not seen an extended bear market in that time.
Momentum has been growing in public opinion and is also the factor with the largest AUM in passives. For momentum specifically, I feel mutual funds are the best option due to the tax benefit on the churn rate.
There are single factor funds and multifactor funds. What should MFDs recommend?
In terms of factor investing, I mentioned that over the last decade, momentum has been strong in India, value has outperformed in the past 4–5 years and quality led from 2010 to 2020. Quant strategies typically focus on value, quality and momentum, often using a multi-factor approach.
This makes sense because factors like stocks are cyclical—no single factor consistently outperforms. A multi-factor approach helps smoothen returns by balancing uncorrelated factors, minimizing underperformance during specific cycles. Many quant funds adopt this strategy to provide a more stable investment experience for end investors.
So, if you are offering quant funds to end investors, it is worth having a combination of factors.
Some say equity PMS are quite similar to mutual funds. So, what advantage or how do PMS offer diversification to an investor's portfolio?
Mutual funds are by definition pooled fund makers, which leaves no scope to customize the portfolio. This customization is where PMS can add an advantage.
PMS also has no position limit. For example, in one of our quant strategies, we have a 15% allocation towards just one company in our top holdings. This would not be doable in mutual funds, which have an allocation limit.
I also wanted to ask you about the new asset class. How do you see that affecting the PMS landscape?
In terms of the new asset class, I think they could lead to confusion for existing PMS investors. Originally, there were two categories of regulated fund manufacturers investing in stocks with mutual funds and PMS. Now you have something in between with the Rs. 10 lakh ticket size for the new asset class.
Additionally, it has the leeway for derivatives and single stock exposure which can be around 15%. It can make investors confused as to whether this is a replacement for PMS.
Considering the new asset class is a pooled vehicle, I would say PMS is much better suited for customized portfolios.
So, there are quite a few strategies in PMS. So, how can wealth managers shortlist them for their clients with PMS?
It depends on the type of investor. Are they growth investors or are they more valuation sensitive investors? What kind of style and risk are they comfortable with?
Another aspect is what investment philosophy are investors aligned with and what suits their goals. I do not think you should look at past returns when choosing PMS, as they are backward looking. The last three-to-five-year returns are a contrarian indicator rather than anything else.
So, for PMS, it is important to focus on understanding the fund manager’s approach, ensure it aligns with your goals and commit to a 5–7 year horizon to make an informed decision.