What is low volatility investing?
To understand low volatility investing, one has to first understand volatility. If the share price moves up and down rapidly over short periods of time the stock is said to be highly volatile. Read more about volatility here.
Low volatility investing strategy is a smarter asset allocation approach which aims to offer better risk-adjusted returns over the long run. It is generally accepted that risk, denoted by volatility, and return on investment are correlated. Hence, higher risk should ideally yield higher returns. However, recent research has shown that, in stock markets across the world, low risk stocks have consistently outperformed high risk stocks and provided higher returns. This effect termed the “Low Risk Anomaly” challenges the basic notion of risk return trade off and is the bedrock of low volatility investing. In simple words, low volatility investing offers better returns at lower risk levels by deriving portfolio weights through volatility, instead of keeping it equal-weighted or market cap weighted.
Low volatility investing in India
Our research confirms that low volatility investing works very well in the Indian stock market. Sharpe ratio is the best measure for calculating the quality of any financial instrument. It measures the extra returns over the risk free rate (bank FDs, return on government 10-year bonds) generated by the instrument for every unit of risk. In a nutshell, higher the sharpe ratio higher is the return offered for the same level of risk. Thus, an instrument having higher sharpe ratio is always better.
For example, if X mutual fund has a higher sharpe than Y mutual fund, its much better to invest in X. Similarly, if Nifty ETF has a better sharpe than X mutual fund, its better to invest in Nifty ETF for the long-term. We have calculated the sharpe ratio of our Low Risk 15 smallcase and compared it with Nifty Index, Nifty 100 index and the most liquid Nifty ETF – Nifty BeES to establish that it offers the best risk-adjusted returns.
How is the Low Risk 15 smallcase created?
The smallcase defines the top 100 stocks by market capitalisation listed on NSE as its investment universe. It leaves out stocks that have been listed for less than 1 year. 1 year volatility of the rest of the stocks is calculated and ranked in ascending order. Hence, the least volatile stock is assigned the lowest rank and vise versa. The top 20 stocks from this list are selected and stocks whose market price is greater than Rs 1800 are further excluded in order to ensure investability for retail investors. The stock weight is calculated as the ratio of the inverse of the stock volatility to the sum of the inverse of stock volatility of all constituents.
Compared to any other ETF available in the market, the Low Risk 15 smallcase is extremely liquid and allows to take long term equity exposure at minimal levels of risk.
Further, as per our study, it handsomely outperforms all the other instruments, as shown in the chart below.