Market risks underpriced, returns may be muted in the medium term, says Marcellus' Chief of Quantitative Research

Expert view on markets: Krishnan V R, Chief of Quantitative Research at Marcellus, believes that due to disruptive forces like Gen AI, tariffs and geopolitical tensions, elevated uncertainty will persist in the markets. In an interview with Mint, Krishnan said that due to the elevated valuations across segments, the returns could be muted in the medium term. Here are edited excerpts of the interview:

What is your medium-term outlook for the Indian equity market? Do you anticipate a period of low volatility going forward?

Given the elevated market valuations across the bulk of mid and small-cap space and even among large caps, I think return expectations would be muted over the medium term.

Market cap-weighted equity indices have delivered spectacular returns over the last five years.

As we wade further into the market cycle, I think company-specific fundamentals like profitability and growth should matter more.

In my opinion, given the number of disruptive forces like Gen AI, tariffs and geopolitical tensions, elevated uncertainty is here to stay.

Are markets currently overlooking any key risks? What potential triggers could disrupt the ongoing positive momentum?

The recent market rally suggests that markets are expecting an improvement in earnings growth in FY26/27, backed by an improving macro.

When seen against the backdrop of elevated valuations, I don’t think markets are fully pricing in the risks of a messy, protracted negotiations of tariff and trade-related issues with the US and structural issues like low wage growth.

How would you assess the Q4FY25 earnings season? Did the results align with your expectations? Do you foresee Q1FY26 delivering stronger numbers?

Earnings growth for the Nifty 50 has been in mid-single digits in Q4FY25. The bulk of the earnings outperformance is being driven by banks and downstream oil marketing companies.

Consumer companies are reporting weak volume growth, margin headwinds, and muted demand commentary.

Difficult to comment on the quarterly outlook due to seasonality in many businesses, but broadly, we should see some margin benefit to companies from lower prices of crude oil and derivatives in Q1FY26.

Mid- and small-cap stocks have recently outperformed. Do current valuations offer comfort, or is there a case for caution?

If we look at valuations of small-cap and mid-cap indices, then at an aggregate level, both are trading above historical averages.

However, valuations should be seen in the context of growth outlook, profitability and management’s execution, which is stock-specific.

Because the small and midcap segment in India includes everything apart from, say, the biggest 100 stocks, it offers plenty of opportunities to pick good quality businesses with strong growth runways.

Given the current market dynamics, what should be the ideal investment strategy? Should investors consider increasing their allocation to gold?

Diversification is the only free lunch in investing. Hence, the ideal investment strategy should be to diversify across uncorrelated asset classes and have an asset allocation plan in place.

So, if someone is primarily invested in Indian equities, they should consider adding gold, global equities and bonds, fixed deposits or even REITs/Invits to the mix.

Even though post-tax returns for debt investment could be suboptimal, they ensure that investors have funds for major financial goals when they need them.

It is difficult to ascribe a fair value to gold, as prices are determined by supply and demand dynamics and safe-haven status.

Since Gold prices have risen around 18 per cent annually over the last five years, I think most investors should allocate 10-20 per cent to gold at this point.

How effective are quantitative models in generating alpha during periods of heightened market volatility?

Because Quant models follow a systematic, rules-based portfolio construction process, they are less likely to be affected by emotions of greed and fear and biases which can affect even the best discretionary fund managers. 

Most quant funds focus more on risk management, for example, by constraining allocation to a single stock or sector. 

Further, most factor-based quant strategies typically combine multiple factors like value, momentum and quality. For all these reasons, a well-designed quant strategy can be expected to deliver consistent alpha across market cycles.

How do you view the evolution of quantitative strategies in India compared to global markets? What trends are shaping their growth?

Quant funds are still a relatively new concept in India, at least for retail investors. Asset under management (AUM) in quant strategies, according to a Forbes article, would be less than 1 per cent of overall mutual fund AUM or even equity fund AUM, and nowhere near other developed markets like the US (including factor funds). 

But it has grown faster than the overall equity AUM, and over the last few years, I have seen nearly every major fund house launch a quant or a factor fund. 

I think Indian equity markets are at the sweet spot from a quant investing standpoint. Liquidity has improved beyond just large caps over the last few years, and we have a 15-20-year history on which quant strategies can be tested. 

Overall, I feel that we are still in the early days. As data availability keeps improving, along with the means to extract and analyse data using modern computing techniques, and as existing quants build performance track records, investor awareness and flows should be strong.

Since quantitative models heavily rely on historical data, how significant is the risk that past patterns may not repeat in future market conditions?

History seldom repeatsbut often rhymes. However, if back-test returns are the sole criteria for selecting the winning strategy, then there is a significant risk of future underperformance, especially if there is a regime change. 

In India, unlike developed countries, reliable historical data is available only for 20-25 years, which may be sufficient but not enough. Our approach is to back-test only as a guide and mainly to rule out a bad strategy. 

A well-thought-out quant model is based on sound economic rationale with room to evolve based on changing market conditions.

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Disclaimer: This story is for educational purposes only. The views and recommendations above are those of individual analysts or broking companies, not Mint. We advise investors to check with certified experts before making any investment decisions, as market conditions can change rapidly, and circumstances may vary.