Most investors want a portfolio that performs consistently and does not fluctuate dramatically with market moves, particularly on the downside. To meet this goal, investors can choose a smart-beta or factor-based investment approach that focuses on low volatility. Factor or rule-based investment combines the advantages of passive and active investing, and low volatility indices allow investors to create a portfolio that does not fluctuate dramatically.
In general, low-volatility investing means that an index falls less than the broader market during declines while maintaining reasonable participation during rallies. The Nifty 100 Low Volatility 30 Index is a benchmark index available to investors. There are other multi-factor indices available that include low volatility as a major feature. For example, consider the Nifty Alpha Low Volatility 30 Index.
Lower Volatility for Reduced Risk
Essentially, a low volatility strategy is purchasing companies or an index of such stocks with relatively stable price movements. Lower volatility means fewer fluctuations, less uncertainty, and fewer dangers as compared to the broader market. Statistical indicators such as beta and standard deviation, among others, are often employed to assess risks and fluctuations.
Typically, low volatility equities perform well during tumultuous markets when investors seek relatively safe investments. Three main market factors contribute to the strategy's effectiveness.
Many investors irrationally choose to invest in highly volatile stocks in the hope that they will become multi-baggers and that they will be purchased at a premium valuation. Low volatility stocks are frequently ignored or undervalued by investors. This is known as the lottery effect.
The overconfidence impact occurs when investors have excessive (sometimes erroneous) confidence in their ability to anticipate earnings for the future of highly volatile enterprises. They end up painting overly optimistic scenarios for high volatility equities, which may result in disappointment.
The third and most crucial element to consider is the possibility of asymmetric rewards. Low volatility equities and indexes fall far less than the overall market during falls. These lesser falls typically compensate for the relative underperformance during market rallies. As a result, the overall returns are strong when adjusted for risk.
There are two types of shocks that create market volatility:
Endogenous
Endogenous shock occurs when a period of instability, recession, or a difficult macroeconomic environment is caused by causes inherent in the economy. Examples include the global financial crisis, demonetization, sovereign defaults, and trade wars.
Exogenous
Exogenous shocks originate from forces outside a country. Examples include the Russia-Ukraine war, tensions between Israel and Hamas, COVID-19, SARS, and an increase in oil prices. A low volatility approach would aim to help weather exogenous obstacles while hedging the portfolio reasonably against endogenous risks.
Playing Low Volatility using ETFs
For an investor, investing in an index such as the Nifty 100 Low Volatility 30 provides an opportunity to reduce the impact of market volatility on their total portfolio. This strategy provides exposure to the least volatile stocks from the large-cap pack.
During the global financial crisis of 2008, even large cap frontline indices plummeted 51-54%. However, the Nifty 100 Volatility 30 Index (based on back-testing data) fell by slightly more than 43 percent. During the 2011 sovereign debt crisis in Europe, mainline indices plunged 23-25%, whereas the low volatility index lost only 12%. It also delivered larger returns in 2020 than other indices because it fell less during the steep correction that lasted until April 2020.
The low volatility index includes equities from the Nifty 100 index. Stock volatility is calculated as the standard deviation of daily price returns over the past year. They should be available for trading in the derivatives markets. The index will include the top 30 stocks with the least volatility.
The Nifty 100 Low Vol 30 index outperforms the Nifty 100 TRI in terms of risk adjusted returns. So, if you're seeking a low volatility product, an ETF or Fund of Fund (FoF) approach to investing in the low volatility index might be a good choice. Alternatively, investing in low volatility-based offerings might serve as a beginning point for one's equity adventur
