Consider MFs investing in low volatility stocks | Economic Times

Can selectively picking less volatile stocks from the large-cap universe yield better results over the long term? This is the premise of the factor-based offering ICICI Prudential Nifty 100 Low Volatility 30 ETF FoF, which is based on the ETF launched back in 2017. Let’s explore if there is merit in pursuing such a strategy.The travails of actively managed large-cap funds over the past few years are known. Barring a couple of outliers, most funds in this basket have lagged the frontline indices. This has left investors disillusioned, many turning to lower cost index-based offerings instead. However, even plain vanilla index funds are not immune to routine market volatility. For investors looking for more stable returns, selective participation in least volatile stocks is a way out. ICICI Prudential’s Nifty 100 Low Volatility 30 ETF Fund of Fund offers a readymade construct of 30 least volatile stocks among the top 100 names by market capitalisation. The underlying factor-based index ranks stocks according to their volatility score—measured by standard deviation in stock price over a one-year period. The top 30 stocks with least volatility form a part of the index, with the least volatile getting the highest weights. 81884595How different is this fund from what frontline index offers? By virtue of its low volatility emphasis, the top three sectors by weight in the index are consumer goods, IT and automobiles. These are traditionally considered defensive plays. Banking stocks which together with NBFCs form nearly 40% of the Nifty100 index take up just 8.6% of the Nifty100 Low Volatility 30 index. Power Grid Corporation of India, Dabur India, Ultratech Cement, Indian Oil Corporation and Bajaj Auto are the top constituents of this index. This distinct composition lends it a completely different risk profile. Not only is the index characterised by lower volatility, but its valuation profile is also more benign. The Nifty100 Low Volatility 30 index currently trades at 24.5 times whereas Nifty100 and Nifty50 indices trade above 39 times earnings. All this appears favourable but does it translate into raw performance? After all, low volatility or low risk is often perceived to imply lower return. The performance of the underlying index does show better outcomes over longer time frames vis-a-vis Nifty100 and Nifty50. The low volatility index has outperformed the frontline indices over seven and 10 year time frames. However, it has lagged behind over three and five-year time periods. Since 2008, the low volatility index has outperformed the frontline indices eight out of 13 calendar years. This seems to counter the notion that lower risk equals lower return. On a risk adjusted basis, the performance appears even better—the Nifty 100 Low Volatility 30 index has fetched higher risk-adjusted return than both Nifty100 and Nifty50 over the past one, three and five years. This is referred to as the ‘low volatility anomaly’. Anish Teli, Managing Partner, QED Capital Advisors, explains: “Investors usually crowd high risk bets in pursuit of higher returns, which often leads to these stocks getting overpriced and future returns disappointing. The opposite happens with the low risk or low volatility basket, which tends to get underpriced and ultimately fetches better returns.”A simple reason for low volatility stocks doing well is the inherent ability to limit downside. Vikas Gupta, CEO and Chief Investment Strategist, OmniScience Capital, argues, “Low volatility is an outcome; the cause is stable fundamentals of the companies. These offer predictable growth and healthy profitability and this is reflected in stock price movement.” The more a stock’s price falls, the more it has to gain to get back to even. If a stock loses 50%, it has to gain 100% to get back to even. A stock that falls lesser doesn’t have to ride a large uptick to regain lost value. If a stock loses 25%, it has to gain 33% to recover. This in theory serves a basket of low volatility stocks well over the long term. This strategy helps stave off large drawdowns during major downturns, which holds it in good stead over entire market cycles. However, low volatility will not always do well. Like any other factor, it shines during specific phases of the market cycle. There will be periods when this strategy underperforms. The past one year is a case in point—stark underperformance has pulled down the index’s return profile over three and five years. “Every factor goes through its seasons and it is very difficult to time factors accurately,” insists Teli. Factor-based strategies are best harnessed when used in conjunction with others. For instance, a combination of low volatility with high alpha, quality or even momentum factors may yield better results. Also, these strategies should not be substitutes for core portfolio investments. These can be used to complement existing investments in index funds or flexi cap funds.(Graphic by Sadhana Saxena/ET Prime)