Most investors look forward to having a portfolio that is steady in its performance and does not fluctuate wildly with market movements, especially on the downside. To cater to this need, a smart-beta or factor-based investing style with low volatility as the focus is available for investors. Factor or rule-based investing combines the best of passive and active styles of investing and low volatility indices offer the opportunity for investors to build a portfolio that does not gyrate sharply.
Broadly, as a factor, low-volatility investing means that an index falls less than broader markets during periods of corrections, while ensuring reasonable participation during rallies. The Nifty 100 Low Volatility 30 Index is a benchmark index available for investors. There are multi-factor indices available as well which has low volatility as a key ingredient. For example: The Nifty Alpha Low Volatility 30 Index.
Lower Volatility for Reduced Risk
Essentially, a low volatility strategy means buying stocks or an index of such stocks that have a fair degree of stability in their price movements. Lower volatility means lower fluctuations, lower uncertainty and lower risks compared to the broader markets. Statistical measures such as beta and standard deviation among a few other metrics are commonly used to gauge risks and fluctuations.
Usually, low volatility stocks tend to do very well during turbulent markets when investors seek relatively safer investments. The strategy works due to three key market factors that come into play.
Many investors irrationally prefer to invest in highly volatile stocks hoping they would turn into multi-baggers and even pay high valuations while buying them. They tend to ignore low volatility stocks or underpay for them. This is called the lottery effect.
Overconfidence effect results from investors having too much (often misplaced) confidence in their ability to forecast earnings for the future of companies that are highly volatility. They end up painting highly optimistic scenarios for high volatility stocks, which may end in disappointment.
The third and most important factor at play is the prospect of asymmetric returns. Low volatility stocks and indices fall a lot less than the broader markets during declines. These lower falls tend to substantially compensate for the relative underperformance during market rallies. Thus, the overall returns are robust on a risk-adjusted basis.
There are two kinds of shocks that cause market volatility – endogenous and exogenous.
When a turmoil or recession or tough macro environment is due to factors that are intrinsic to the economy then it is termed as endogenous shock. Examples may be the global financial crisis, demonetization, sovereign defaults, trade wars etc.
Exogenous shocks come from factors outside a country. Russia-Ukraine war, Israel-Hamas tensions, COVID-19, SARS, oil price spike are some of the examples.
A low volatility strategy would look to help in weathering exogenous challenges, while hedging the portfolio reasonably due to endogenous factors.
Playing Low Volatility Via ETFs
For an investor, the addition of an investment in an index like the Nifty 100 Low Volatility 30 offers an opportunity to limit the impact of market volatility on the overall portfolio. Through this investment, one gets exposure to the least volatile stocks from the large-cap pack.
In the global financial crisis period of 2008, even large cap frontline indices fell 51-54 per cent. However, the Nifty 100 Volatility 30 Index (based on back-testing data) declined by a little over 43 per cent. During the 2011 sovereign debt crisis in Europe, mainline indices fell 23-25 per cent, while the low volatility index declined by a mere 12 per cent. It also delivered higher returns in 2020 compared to other indices as it fell less in the heavy correction seen till April 2020.
The stocks which form a part of the low volatility index is selected from the Nifty 100 index. The volatility of stocks is calculated as the standard deviation of daily price returns for the last one year. They should be available for trading in the derivative segments. The top 30 stocks with the least volatility becomes a part of the index.
On a risk adjusted basis, Nifty 100 Low Vol 30 index fares better than the Nifty 100 TRI. So, if you are an investor looking for a low volatility based offering then an ETF or Fund of Fund (FoF) route to investing in the low volatility index would be an apt choice. Alternatively, investing in low volatility based offering can be considered as a starting point to one’s equity journey.