My Experiment With the Nifty Smallcap–Nifty 50 Ratio

I recently came across an interesting strategy by M. Pattabiraman (Pattu) of Freefincal for reducing the risk of small-cap investing.

The basic idea is to compare the relative performance of the Nifty Smallcap 250 TRI and Nifty 50 TRI using a normalized ratio.

I want to be clear at the beginning: this is my own experiment, not an improvement or criticism of Pattu's method. I am simply testing what happens when the same idea is applied differently.

My respect and credit to Pattu for the original idea and the detailed explanation.

Pattu's original Freefincal article

What is the ratio?

I normalize both indices to the same starting value and calculate:

Ratio = Normalized Nifty Smallcap 250 TRI ÷ Normalized Nifty 50 TRI

A higher ratio means small caps have performed relatively strongly compared with Nifty 50.

Pattu uses 1.30 as a trigger in his example.

I tested two approaches

1. SIP-only

I invest ₹10,000 every month.

• Ratio below the chosen threshold → SIP goes to Smallcap 250

• Ratio at/above the threshold → SIP goes to Nifty 50

• Existing investments are never sold

So over time, the portfolio can contain both Nifty 50 and Smallcap investments.

2. Full portfolio switch

Here I take the more aggressive approach:

• Ratio below threshold → entire portfolio is in Smallcap

• Ratio at/above threshold → entire portfolio is moved to Nifty 50

• Monthly ₹10,000 SIP follows the current allocation

This is fundamentally different from SIP-only because the accumulated portfolio is actually switched.

My backtest

Using monthly TRI data from January 2012 and ₹10,000 monthly SIPs, I obtained:

Ratio	Full Switch XIRR	Full Switch Max DD	SIP-only XIRR	SIP-only Max DD
1.20	13.15%	37.39%	11.31%	28.50%
1.25	13.99%	40.32%	11.83%	28.55%
1.30	14.41%	39.89%	12.27%	28.59%
1.35	13.53%	40.07%	12.93%	36.87%
1.40	12.96%	39.48%	13.02%	28.65%
1.45	13.67%	40.22%	13.24%	28.72%
1.50	17.03%	43.34%	13.73%	28.74%
1.55	17.26%	44.43%	13.92%	45.57%
1.60	15.52%	44.59%	14.34%	45.57%

What surprised me?

The 1.30 full-switch strategy produced 14.41% XIRR versus 12.27% for SIP-only in my test.

But there is a price for that additional return.

Maximum drawdown was approximately:

• Full switch: 39.89%

• SIP-only: 28.59%

So the full-switch approach generated a higher historical return, but it also exposed the portfolio to substantially larger drawdowns.

Interestingly, the 1.50–1.55 thresholds produced even higher historical returns. However, I would not automatically call these "better". They may be heavily influenced by the particular market cycles in this test.

For me, 1.30 looks like the more reasonable balance between return, drawdown and number of switches, rather than simply choosing the threshold with the highest backtested return.

One final thought: Why not simply use active funds?

This experiment also made me think about a simpler alternative.

Instead of switching between Nifty 50 and Nifty Smallcap 250 ourselves, why not use a good flexi-cap fund and a well-managed small-cap fund?

An active fund manager can change allocations, avoid some weaker companies, and potentially move away from expensive or poor-quality stocks. A flexi-cap fund also has the flexibility to invest across market capitalisations.

That raises an interesting question:

Is this ratio-based strategy actually worth the extra complexity, or is it better to simply hold a good flexi-cap fund + managed small-cap fund and let the fund managers make those decisions?

I don't have a definitive answer yet. That would require a separate, fair comparison using actual fund data, including expenses, taxes, exit loads, survivorship bias and the fact that many funds did not exist throughout the entire backtest period.

For me, that is probably the more interesting next experiment.

Important limitations

This is only a historical index backtest. It does not mean the strategy will work in the future.

The actual implementation using mutual funds or ETFs can produce different results because of:

• Taxes and exit loads

• Tracking error

• Expense ratios

• Transaction costs

• Execution timing

• Differences between index and investable products

• Human behaviour during large drawdowns

• Future market conditions being different from the past

The 1.30 threshold is also not a magic number. It is a rule based on historical behaviour and should not be treated as an optimal or guaranteed threshold.

Most importantly, backtesting can make a strategy look easier than it is to follow in real life.

Disclaimer

I am not a financial analyst, SEBI-registered Investment Adviser, or approved financial adviser. I am sharing this purely as my personal research and experiment, not as investment advice or a recommendation to buy, sell, or switch any mutual fund, ETF or index.

Please do your own research and consult a qualified financial professional before making investment decisions.

All returns and drawdowns shown above are based on my backtest and historical data. Past performance is not indicative of future results.

Finally, full credit to Pattu/Freefincal for the original small-cap ratio concept. My experiment simply explores what happens when that concept is applied using a full-portfolio switch versus continuing SIPs without selling existing holdings.