Insights

FundsIndia Strategies: Why a low volatile strategy wins

July 1, 2015 . Vidya Bala

When many of you come with your own choice of funds – be it sector funds, or aggressive top charters in the equity space, we often tell you that we prefer consistent, low volatile funds to high-beta funds (call them chart toppers or aggressive funds, you name them) for we believe they will deliver optimal returns over the long term.

Barring a few exceptions, those are the kind of funds we prefer to retain in our Select Funds list.

While it is difficult for us to label all funds as high beta funds and low volatile funds as many of them change their tack across different markets, when we do our review, we ensure that we retain low volatile funds that deliver optimal risk-adjusted returns.

Now, I am going to prove the point that low volatility wins by providing you some very interesting data – not from funds, but from indices. The National Stock Exchange has some less-popular (and not traded) strategic indices, among which feature the CNX Low Volatility Index and the CNX High Beta Index.

These indices are 50-stock indices (launched in November 2012) chosen as follows: The top 300 stocks in terms of market cap are chosen, and the least volatile among them (low standard deviation based on daily prices for a year) are ranked and added to the index. Low standard deviation implies that the swing in returns from the mean is low.

Similarly, for the high-beta index, 50 stocks (from the top 300) that have high beta when correlated to the Nifty are chosen. When we mean high beta, these are stocks that move higher than the Nifty in a rally, and fall more than the Nifty in a downturn.

Although, the indices were constituted in 2012, they have a base date from 2003 and hence, we have data for a longer period. The returns below will surprise you:

table1_July1

Now, I do not want to get into the constituents of this index, nor will I tell you how to construct one. But it is indeed paradoxical that low volatility should win. After all, it does go against the very core of investing tenets – higher the risk, higher the returns.

Honestly, I have no further research on the already existing well-researched topic of the low-volatility paradox – that is research on why low volatility stocks/portfolios have outperformed world over. But I’d like to offer some simple insights on why low volatility makes sense for your portfolio returns – a fact you saw in the above indices and will see in your own fund portfolios over the long term.

Why low volatility works

Matter of compounding: Let us suppose you invested Rs. 10,000 in a low volatile fund and it fell by 10 per cent. Now for you to get back your capital of Rs. 10,000, you would have to earn an interest of 11 per cent. If you had invested the same money in a high-beta fund that fell by say 20 per cent, the fund would have to deliver 25 per cent to give you back that Rs. 10,000.

This means that while opportunities in the market remain the same, the high-beta fund will have to work far more hard (by betting more on high risk opportunities) to deliver you that 25 per cent to reach Rs. 10,000.

What does this tell us? If you keep the volatility low, you have less to make up and in the process, you need to take lesser risks again!

Enamoured by glamour: When funds invest in stocks that are the flavour of the market, and have shown doubling or tripling of money, not only are they overbought (and therefore quickly over priced), but their return expectations too also run high.

Even as they become overpriced, any let down in expectations (lower earnings growth than anticipated) also means that they are punished hard. On the other hand, the less glamorous, stable companies that are not in the race, perform quietly, delivering value. As there would have been no froth in their prices, there arises a genuine, performance-driven re-rating in these stocks.

Stable in cash flows and earnings: While this is not often the case, low volatile stocks tend to have stable cash flows. They are seldom at a stage where they are leveraged to the hilt with ambitious plans. They could be in small sectors (but leaders in their segments), or in high cash flow businesses.

As a result of such stability, there is seldom any ‘flash news’, or sudden disappointments in their performance. That means sharp de-ratings or hype do not often happen. Of course, this does not mean that they are immune to market or sector downturns. For instance, a good auto component company could be hit as a result of an economic downturn. However, low leverage and the ability to hold on to its market share may see the company ride the downturn and climb with ease in a revival.

The caveat in all this is simple – low volatile stocks can underperform in prolonged rallies as the market is busy chasing the hot stocks. This is where patience pays.

While the above discussion was mostly about stocks, your equity fund portfolio is nothing but a basket of stocks. Apply the same logic to funds and you will see why a low volatile fund makes more sense. When it comes to building wealth, your first priority should be to mitigate capital erosion. That is where a low-volatile strategy scores.

The next time you wonder why some high-return fund was not a part of our Select Funds list, do recollect these few points. For our part, we will, when we do our next quarterly review, throw some light on the volatility and risk-adjusted returns of some of the funds in our list.

Happy investing!

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis of investment decisions. To know how to read our weekly fund reviews, please click here.

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