Low Volatility Investing Decoded

Published: October 31, 2023 at 6:00 am

Low volatility investing is a factor-based investment strategy. It involves picking a basket of stocks that exhibit the least standard deviation in daily returns over the preceding 12 months.

About the author: Akshay holds an MBA in Finance from Great Eastern Management School, Bangalore. His website is akshaynayakria.com. His articles on personal finance and investing can be accessed here: akshaynayakria.com/blog.

The stocks are picked from a particular universe, usually a broad market index. The strategy works based on a phenomenon known as the Low Volatility Anomaly. It refers to the observation that long term returns from low-volatility stocks are comparable or higher than the index from which they are chosen. This is true for most regions and markets studied. The strategy, therefore, offers higher long term returns while exposing investors to a relatively lower degree of risk. This contradicts the traditional notion that investors wishing to beat the market must take a higher risk.

Explanations In Support Of The Low Volatility Strategy 

There are multiple explanations as to why low-volatility investing works. These explanations are born from traditional finance, behavioural finance and statistics.

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Leverage Aversion: One of the most popular explanations supporting low-volatility investing is the concept of leverage aversion. It is linked to the Capital Asset Pricing Model (CAPM). The CAPM studies the differential return an investment asset generates over the risk-free rate. The CAPM assumes no costs are involved in any market transactions investors execute.

It also assumes that investors can borrow as much capital as required at the risk-free rate. In other words, the CAPM assumes that investors operate under perfect market conditions. It, therefore, propagates that all investors should hold the market portfolio through a broad market index fund. Those who wish to take more risk than the market should hold a broad market index fund with a commensurate element of leverage or debt.

Theoretically, this would be easy owing to the CAPM’s assumption of perfect market conditions. But in reality, perfect market conditions may not exist. Therefore, an investor who wishes to take, say, 15% more risk than the market would simply buy stocks with a beta of 1.15 and hold them. The beta of the market is always taken to be equal to 1.

So, investors who buy stocks with a beta of 1.15 automatically take 15% more risk than the market. And when several investors adopt this strategy, the prices of high-beta stocks get pushed to a point that their fundamentals cannot justify. This automatically reduces the expected future return on these stocks. The low volatility strategy avoids such stocks, thereby delivering better returns.

Avoiding Untested Stocks: Another explanation for favouring low volatility investing stems from behavioural finance. Behavioural finance works because investors are irrational and do not think their decisions through properly. This repeatedly causes them to prefer purchasing untested, highly volatile stocks. They do this, hoping that those stocks become the next big multibaggers. So, they effectively pay a premium for the volatility in such untested stocks. The low volatility strategy systematically avoids such stocks. This protects investors against the higher degree of risk associated with them. As a result, investors enjoy better returns.

Dispersion: The final explanation supporting low-volatility investing is connected to a statistical concept called dispersion. Dispersion studies the variation in a set of values observed in a data set, most commonly around the average of those values. When applied to stocks, dispersion can be used to study the variations in the returns of the stocks within an index around the index return.

Dispersion is usually high when markets are down, and stocks perform badly. The low volatility strategy outperforms during periods of high dispersion. Outperformance achieved during such periods is likely to be disproportionately rewarded. Dispersion tends to be low when markets are high, and stocks perform well. The low volatility strategy underperforms during periods of low dispersion. But underperformance during such periods is unlikely to be penalised heavily.

In other words, the low volatility strategy allows investors to participate in bull markets. It also protects bear markets. This represents a viable pattern of long term returns for investors. It must, however, be understood that neither the participation nor protection offered by low-volatility investing is perfect. Portfolios using the low volatility strategy may not rise as much as the market during a bull run. There will also be periods when the strategy loses money for investors, albeit much less than most other strategies.

Benchmark Low Volatility Indices In India: It is important first to understand the construction and composition of the major low volatility benchmarks in India. The first among them is the Nifty 100 Low Volatility 30 Index. This index comprises the 30 least volatile stocks within the top 100 listed on the National Stock Exchange (NSE). This effectively means that the universe of stocks in this index is derived from stocks within the Nifty 50 and Nifty Next 50. As far as low volatility benchmarks for the Sensex are concerned, there is the S&P BSE Low Volatility Total Returns Index. It comprises the 30 least volatile stocks within the S&P BSE LargeMidCap index.

Building A Portfolio Of Low-Volatility Stocks: When adopting low-volatility investing as a strategy in our portfolios, the first option is to look up the constituents of the low-volatility benchmark of our choice and pick a set of stocks among them. The relevant data on the constituents would be available on the NSE and BSE websites. The data for these indices would be updated monthly.

We would then need to look at the list of top constituents, pick stocks among them and hold them. But we must remember that the top constituents are updated every month. This means we need to keep track of the top constituents every month. If one of the stocks we hold drops out of the list of top constituents in a particular month, we would need to remove that stock from our portfolios and replace it with another of the top constituents. So, there would potentially be an element of active management and portfolio churn involved if we choose to follow this approach.

ICICI Prudential Nifty Low Volatility 30 ETF Fund Of Funds: Those who prefer a passive approach to low-volatility investing can opt for a low-volatility ETF or index fund. ICICI Prudential Nifty Low Volatility 30 ETF tracks the Nifty 100 Low Volatility 30 index. The product is also available as a Fund of Funds (an open-ended mutual fund scheme that invests in the ICICI Prudential Nifty Low Volatility 30 ETF).

As an ETF, the ICICI Prudential Low Volatility 30 ETF eliminates the need for active management. But as with any other ETF, investors may be exposed to significant price-NAV deviations. Then, investing in the Fund of Funds variant is available. Investors must note that the ETF currently has an expense ratio of 0.41%. In addition, the direct plan of the Fund of Funds would carry an expense ratio of 0.11%. So, the Fund of Funds would have to generate a higher return just to keep pace with its benchmark index. All of this points towards the fact that the ICICI Prudential Low Volatility 30 ETF and its Fund of Funds variant may not represent an ideal option for investors looking for a passive approach to low-volatility investing.

UTI S&P BSE Low Volatility Index Fund: Another passive option available to investors is the UTI S&P BSE Low Volatility Index Fund. This fund tracks the S&P BSE Low Volatility Total Returns Index. The expense ratio of the index fund is currently 0.44%. As a traditional index fund, investors would not be exposed to the risk of price–NAV deviations inherent to ETFs. So, it represents a better passive option for investors than low-volatility ETFs and Fund of Funds.

Investors must remember that this fund is a passively managed active mutual fund. The index curator would pick a set of low-volatility stocks based on preset rules for inclusion in the index. The curator can always change the rules for stock selection in the future. If this were to happen, the fund’s risk factors and expected returns may also change accordingly.

Benefits Of The Low Volatility Strategy: The low volatility strategy is based on the price movement of stocks. Therefore, investors need not study valuations, accounting metrics or financial statements when picking stocks based on the strategy. Also, stocks that satisfy the low volatility criteria are mainly those of companies that have a stable business, clean books of accounts and well-established reputations. So, investors can be confident of holding an equity portfolio of reasonable quality when following the low volatility strategy.

Ideal Reasons For Using The Low Volatility Strategy

Investors must use the strategy only when :

  1.  They clearly understand the concepts and risks underlying the low-volatility strategy.
  2. They appreciate the inherent characteristics of low-volatility stocks.
  3. They accept a higher risk-adjusted return than a broad market index.

There is a real possibility that long term returns from low-volatility portfolios may be lower than the returns of the broad market indices on an absolute basis. Therefore, investors who wish to use the strategy purely to outperform broad market indices may be disappointed.

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