The rise in the equity market is never linear; volatility is the inherent nature of the market. The investing style of picking stocks that are less volatile than the broader market is a low-volatility strategy.
The volatility here is decided by calculating the standard deviation of daily price returns of the stock for the last one year; low volatility means finding those stocks whose standard deviation is less than 1 or less volatile than the benchmark, said Dilshad Billimoria, board member, Association of Registered Investment Advisors (ARIA). Simply put, it considers the fluctuation of share price from its average price during a certain period.
A low-volatility investing strategy involves creating a basket of stocks based on the volatility score. Thus, the fundamentals of the companies are not considered while picking stocks. This strategy has proven to offer good downside protection during market corrections but has been a laggard in the rising market, as per the data from the past (see chart).
Funds in India
In India, there are currently five funds focussing on the low volatility strategy theme: Motilal Oswal S&P BSE Low Volatility Index Fund & ETF, UTI S&P BSE Low Volatility Index Fund, Kotak Nifty 100 Low Vol 30 ETF, ICICI Pru Nifty Low Vol 30 ETF & FOF and ICICI Pru Alpha Low Vol 30 ETF & FOF.
These are low-cost passive funds tracking the low-volatility indices designed by the BSE or NSE.
BSE’s S&P BSE Low Volatility Index track the performance of the 30 companies in the S&P BSE LargeMidCap with the lowest volatilities. And the NSE’s Nifty 100 Low Vol 30 Index aims to capture the performance of the 30 least volatile stocks in the NIFTY 100 index.
Further, the Nifty Alpha Low Volatility 30 Index is a multi-style factor fund that identifies 30 stocks based on a combination of alpha (ability to beat market returns) & low volatility from Nifty 100 & Nifty Midcap 50 Index.
By the inherent nature of the low volatility factor, the indices have been historically made up of companies across defensive and consumer-centric sectors such as FMCG and Pharma. These indices usually have lower exposure to cyclical sectors and higher volatility stocks.
The stocks that are part of the low volatility index are considered ‘low-beta’ stocks (less volatile). “Thus, we typically find that they go down lesser than markets go down, but they also go up lesser than markets go up." said Vishal Dhawan, founder and director of Plan Ahead Wealth Advisors.
This has been proven in a couple of instances when markets witnessed correction (see table). For example, during the global financial crisis of 2008, the Nifty’s low volatility 30 index fell 48% compared to about 60% correction in Nifty 100 and Nifty 50 indices.
Should you invest?
Expert views on the low volatility investing strategy have been mixed and hence some suggest pairing a low volatility strategy with another strategy such as momentum investing (which is also followed by some mutual funds and ETFs).
Shyam Shekar, founder of ithought Financial Consulting LLP, believes that the low volatility investing strategy may not work in the inflationary environment, which India may witness going ahead. “My view is most of the stocks which are classified as low volatile are going to be very volatile going ahead. When costs inflate uncontrollably, business volatility rises. If the business volatility rises, then you will find earnings volatility rise and resultantly, the stock volatility in the market also rises," he said.
“Investors will be able to ride out the volatility by having a long-term horizon. Many of the investors are already participating in the market through systematic investment plans (SIPs), which is a methodology of dealing with volatility in an asset. So, we think by adding more downside protection to the portfolio through low volatility investing may not necessarily add that much value to long-term investors," he added.
Yet, many believe that these funds can be a good starting point for someone worried about market volatility and as a complementary strategy for high-risk equity holdings.
“A low volatility ETF/Fund can be a good option for conservative or first-time equity investor who wants to invest in equities with moderate to lower risk than even the broad-based indices like Nifty/Sensex. This can also be useful as a blend or portfolio style diversification strategy for an investor with high-risk equity portfolios of mid/small-cap funds or direct stocks" said Nishant Agarwal, managing partner & head - family office, ASK Wealth Advisors.
Anish Teli, managing partner of QED Capital Advisors LLP, said that one can consider combining investing in low volatility funds with another style of investing, say momentum, which means buying stocks with high returns over a period. “Momentum part keeps you in the relevant side of the bucket, which is doing well and the low vol part keeps you in the not very volatile side of the market, but one which is relatively smoother," he added.
