Can we beat indices like the Nifty Next 50 (NN50) by simply picking stocks with low volatility?! Regular readers may be aware that I am running a series on the NN50. In the fourth and final part (for now), we compare Nifty 50, (N50), NN50, NIfty low volatility and the NIfty multi-factor indices in search of the holy grail of investing: higher reward at lower risk!
I would strongly urge you to take some time this weekend to read the first three parts: Part one: Warning! Nifty Next 50 is NOT a large-cap index!. Part two: Are Nifty Smart Beta (strategic) Indices better than the Nifty Next 50?. Part three: How new stock investors can quickly start investing using NIFTY Multi-Factor Indices
Before we begin, here are some definitions so that we can all start on the same page. N50: 50 stocks with the highest market capitalization. NN50: 50 stocks with top 51st to 100 market cap. In both these indices, stocks with higher market cap have a higher weight. Nifty low volatility 50: 50 stocks with lowest last 1Y volatility from top 300 market cap stocks. Nifty 100 low volatility 30: 30 stocks with the lowest volatility among NIfty top 100 (= N50+ NN50). In both these indices, stocks with lower volatility have a higher weight.
Nifty strategic index or a smart beta index is one in which stocks are chosen by one or more methods of stock selection instead of simple picking stocks by market capitalization. So by investing in a smart beta index, we combine both active and passive methods of investing. Four methods are used:
1: Alpha is a measure of risk-adjusted outperformance with respect to NIfty 50 and the MIBOR* three-month bond rate representing the risk-free return.
2: Low volatility: a measure of how much monthly stock returns deviation from average (standard deviation)
3: Quality: Stocks with high Return on equity (ROE), low Debt equity ratio (D/E) and high Profit After Tax (PAT) in the last three financial years
4: Value: stocks with high ROCE (Return on Capital Employed), low PE, low PB and high Dividend yield (DY) in the last financial year
NIfty Multi-factor indices
These are constructed with above four metrics:
1. NIFTY Alpha Low-Volatility 30 = 50% alpha + 50% low volatility
2. NIFTY Quality Low-Volatility 30 = 50% quality + 50% low volatility
3. NIFTY Alpha Quality Low-Volatility 30 = 1/3 Alpha + 1/3 Quality + 1/3 Low Vol
4. NIFTY Alpha Quality Value Low-Volatility 30 = 25% Alpha + 25% Quality + 25% Value + 25%Low Volatility
For more details consult: How new stock investors can quickly start investing using NIFTY Multi-Factor Indices
N50 vs NN50 vs low-vol vs Nifty multi-factor: 10-year rolling return
So we shall consider every possible 10-yer window from 2004-5 or earlier. This gives a minimum of about 770 data points for each index. Naturally, this is a small time period, but this is the picture as of now. We will keep reviewing the situation periodically.
N50 vs NN50 vs low-vol vs Nifty multi-factor: 10-year rolling risk (standard deviation)
Please take some time to look closely at both graphs. I can only arrive at this conclusion: Choosing stocks with low volatility is a simple, but effective way to beat the NN50 in terms of risk and reward! Even here, all one needs to do is to look for low volatility among top 100 market cap stocks and choose a few (check other metrics if you are worried). Else simply track the low volatility index. Naturally, we have looked at a small time window, but this to me this looks pretty promising. Intuitively, low volatility implies a company that grows slowly with no sudden developments – good or bad.
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