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.
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 :
- They clearly understand the concepts and risks underlying the low-volatility strategy.
- They appreciate the inherent characteristics of low-volatility stocks.
- 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.
Do share this article with your friends using the buttons below.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
Podcast: Let’s Get RICH With PATTU! Every single Indian CAN grow their wealth!
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter with the form below.
- Hit ‘reply’ to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
Explore the site! Search among our 2000+ articles for information and insight!
About The Author
Dr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu gets a superpower!” is now available!
Most investor problems can be traced to a lack of informed decision-making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision-making and money management is the narrative. What readers say!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. – Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & it’s content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.
Your Ultimate Guide to Travel
This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)
