Can Including Mid and 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, prioritizing 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, and 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.
Source: NSE, MO AMC, Data as of 30th June 2025
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 percent weight in large caps, 20 percent in mid-caps, and 10 percent 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
percent, which is 1.4 percent 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 percent, the Nifty 500 comes in at 16.3 percent. 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.
This decreasing correlation across segments often helps to reduce overall volatility in the Nifty
500. Since all stocks don’t move in the same direction or intensity, their combined effect helps in creating balance. This is a hidden strength of broad-based indices – they’re naturally better positioned to absorb market shocks and moderate extremes.
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. For instance, during the Global Financial Crisis, its volatility peaked at around 46%, well above that of the Nifty 500. Similar patterns were seen during the US credit rating downgrade in 2011, the Taper Tantrum in 2013, and the Covid-19 outbreak in 2020. In each case, the Nifty 50 experienced more pronounced and prolonged spikes in volatility.
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.
A recent example is the Resilient Growth Phase that began in early 2024. While no major crisis occurred, Nifty 500 volatility rose – highlighting a shift toward broader market participation and growing flows into smaller companies.
FPIs share in Listed Market
Nifty 50 tends to show higher volatility during uncertain times due to its higher exposure to foreign institutional investors (FPIs). Historically, FPIs have had a larger shareholding in the top 50 compa- nies, which makes the index more sensitive to global risk sentiment and foreign capital flows.
As of March 2025, FPIs held around ₹45.6 lakh crore in companies that are part of the Nifty 50. In contrast, the total FPI investment in companies ranked 51 to 500 (i.e., the rest of the Nifty 500) was about ₹23.9 lakh crore. The remaining portion of the listed market, which includes microcap com- panies beyond the top 500, had a much smaller share of just around ₹2 lakh crore in FPI holdings.
Over the past couple of years, there’s been a noticeable shift in FPI interest towards companies outside the Nifty 50, but still within the top 500 universe. As of the latest data, roughly 65 to 70 per- cent of FPI flows still go into the top 50 companies, around 30 percent into companies ranked 51 to 500, and only 2 to 4 percent into microcap companies outside the Nifty 500. This uneven distribution historically implied that large cap stocks tend to experience sharper price movements whenever there is buying or selling by foreign investors. It also leads to higher churn in the Nifty 50 compared to broader indices like the Nifty 500, which are more influenced by domestic flows and a wider investor base.
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 percent.
On the other hand, the Nifty 50 is underweight in Healthcare, Services, and Consumer Discretionary, all of which have shown relatively lower volatility, ranging between 16 and 18 percent. These sectors are more demand-stable, less exposed to global shocks, and tend to behave more predictably over long periods.
This sectoral skew contributes to the higher volatility of the Nifty 50 over the long term. Since it is more concentrated in cyclical and globally sensitive sectors, any sector-specific shock or global event tends to impact it more directly. 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.
Such volatility is often a by-product of strong investor interest and optimism in emerging sectors and newer business models. While this growth potential is exciting, it also brings with it a higher level of risk in the short term.
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 broad- er macroeconomic cycles.
While the Nifty 50 may appear more stable on the surface due to its focus on large caps, it often car- ries 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.
Diversification remains one of the most effective tools to manage volatility. By spreading invest- ments across company sizes, sectors, and styles, broader indices like the Nifty 500 help reduce the impact of sudden shocks in any one area. For long term investors, this can offer a more balanced and resilient path, especially in a dynamic and evolving market like India.
Source: NSE; MOAMC.
Distributor: This report is based on survey responses from distributors (including mutual fund distributors, RIAs, and wealth managers) and publicly available information. The findings represent reported views and practices as of 2025 and are intended for informational purposes only. They should not be construed as investment advice or a recommendation to invest in any product or strategy. Past performance may or may not be sustained in the future. The data, graphs, and illustrations used in this document are for explanatory purposes only and may not be adequate for developing or implementing an investment strategy. Investors should rely on the relevant scheme-related documents and consult their financial advisor before making investment decisions.The report does not guarantee accuracy or completeness of the information and disclaims any liability for losses arising from the use of this material.
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