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In our previous blog, we explored the advantages of passive investing and concluded that low-cost Index funds or Exchange Traded Funds (ETFs) are well on their way to becoming mainstream investment options in Indian investors’ equity portfolios.
Going a step further, we explore another buzz word that is on investors’ minds in recent times – Low Vol Index For those of you who are not familiar with the concept, here is a brief explanation:
Low Vol stands for Low Volatility, where volatility is measured by standard deviation. We shall discuss the Nifty 100 Low Volatility 30 Index in this article.
It comprises of 30 stocks selected from amongst the top 100 stocks (by market capitalization), that
have displayed the lowest standard deviation in the past 1 year. Stock with the lowest volatility is given
the highest weightage. The key rule followed is – “Higher the volatility, riskier the security, lower the
weightage”.
Like other indices, this index too witnesses a quarterly rebalancing. The current portfolio’s top holdings are presented in Exhibit 1.
Exhibit 1: Underlying Portfolio Details of Nifty 100 Low Volatility 30 Index
Data as on 30th April 2022
Source: https://www1.nseindia.com/content/indices/Nifty100_LowVolatility30.pdf
Does Low Vol imply low risk for investors?
The Low Vol Index includes equity stocks that have lower volatility compared to other parts of the market. However, this does not rule out negative returns in weak market conditions. To understand this better, we take a look at the risk metrics of the Low Vol index in comparison to Nifty 50 Index & top 5 Large Cap Mutual Funds (MFs) in Exhibit 2.
Exhibit 2: Standard Deviation for Nifty 100 Low Volatility 30 Index, Nifty 50 TRI and select Large Cap MFs:
Data range: April 2019 – April 2022. Standard Deviation calculated using monthly returns of Nifty 100 Low Volatility 30 TRI, Nifty 50 TRI and average performance of 5 large cap mutual funds.
Maximum Drawdown for Nifty 100 Low Volatility 30 Index, Nifty 50 TRI and select Large Cap MFs:
Data range January 2001 – April 2022. Source: ICRA Online Ltd. Max drawdown calculated using monthly returns of Nifty 100 Low Volatility 30 TRI, Nifty 50 TRI and average performance of 5 large cap mutual funds
As seen above, the Low Vol index has a lower drawdown compared to Nifty 50 or actively managed large cap funds. However, it is not without risk. In the Global Financial Crisis, the Low Vol Index would have fallen >45% and taken 21 months to recover to the previous high. Across most of the past crises, the Low Vol Index has fallen a lot lesser compared to its counterparts and has recovered to its peak also much faster.
An important point to note here is that the trend reversed during the recent correction due to Russia-Ukraine War and concerns on inflation. The recent underperformance may be attributed to higher FII ownership of stocks, where the selling has been more as FIIs exit. Also, the valuations for some of the
stocks were stretched and are now normalizing.
the index was launched in July-2016. Prior to that, the index returns are simulated based on the model that it is supposed to follow. Therefore, the real performance of the index can only be measured as in the previous two crises – Covid-19 and Russia-Ukraine. Of the two testing times, it has met its objective
of lower drawdown in one scenario.
Risk may be low, but how does it compare on the performance side?
The Low Vol index has a lower risk profile. However, is limiting downside the only criteria we want to look at? Not really. Performance of the index also merits attention. Let us now look at the performance of the Low Vol Index in comparison to the Nifty 50 index and Large Cap MFs. Refer Exhibit 3.
Exhibit 3: Value of INR 100 invested across 3 categories – Nifty 100 Low Volatility 30 Index, Nifty 50 TRI and select Large Cap MFs:
Data range April 2012 – April 2022. Source: ICRA Online Ltd. Capital growth calculated using monthly returns of Nifty 100 Low Volatility 30 TRI, Nifty 50 TRI and average performance of 5 large cap mutual funds.
(How to read? For large cap MFs, the value of the initial corpus of INR 100 would be INR 149.8 if invested 3 years ago, INR 177.6 if invested 5 years ago)
The Low Vol index has generated a marginal alpha over both - actively managed large cap funds & Nifty 50 in the 3 year period. However, it is on par with Nifty 50 in the 5 year period. The CAGR return (as shown in Exhibit 4 below) also indicates that the alpha generated is not much.
Exhibit 4: CAGR return for Nifty 100 Low Volatility 30 Index, Nifty 50 TRI and select Large Cap MFs:
Source: ICRA Online Ltd. Return calculated using monthly returns of Nifty 100 Low Volatility 30 TRI, Nifty 50 TRI and average performance of 5 large cap mutual funds.
What is the conclusion then - Should one invest in the Low Vol Index or just stick to Nifty 50 as the return over a longer period is similar? Or should one invest in both?
To answer these questions, we revisit the concept of Risk Capital. The first question every investor should answer before investing in Equity is – What is my appetite for loss? For example, on a corpus of INR 100, I am comfortable to lose INR 20 in the worst-case scenario, as I believe over a long period of time equity will generate good returns for me. This means I am okay with a 20% loss on my principal.
As we have observed above, the Low Vol Index has a lower drawdown compared to Nifty 50. Hence, if I can stomach a loss of INR 20, then what is the corpus I could invest if I know that the drawdown in a bad market could be lower in a Low Vol Index compared to Nifty 50?
On average, in the previous crises, the Low Vol Index has fallen ~33% less compared to Nifty 50 (Refer Exhibit 2, excluding the Russia-Ukraine war crisis). For our analysis, we assume a slightly more conservative number of ~25%. Refer Exhibit 5.
Exhibit 5: Capital At Risk would change based on two variables – 1) Drawdown, 2) Appetite for maximum loss
The above indicates, that while the risk remains the same (loss of INR 20), one could put a larger capital at work (INR 100 for Nifty 50 compared to INR 133 for Low Vol Index), which would also grow at a similar pace over a long period of time. This in turn has an impact on portfolio returns due to change in asset allocation. As one increases allocation to equity which has potentially better return profile, over all returns for the portfolio would go up..
To answer our next question - whether allocating to both Nifty 50 & Low Vol Index is a better option, we look at the correlation to see whether diversifying is better.
Exhibit 6: Correlation between Large Cap MFs, Nifty 50 and Low Vol Index:
Source: ICRA Online Ltd. Return calculated using monthly returns of Nifty 100 Low Volatility 30 TRI, Nifty 50 TRI and average performance of 5 large cap mutual funds.
As seen above, the correlation between all three categories is extremely high, which means that there is no diversification achieved by investing in all three.
Concluding thoughts
The Low Vol Index looks promising, especially from an asset allocation perspective as the lower drawdown allows for higher allocation to a growth asset class like Equity which can potentially give better returns over a long time. This could be a good bet for meaningful allocation in the Large Cap part of an investor’s portfolio to capture the Beta of the market.
However, one must remember that the index was launched only about 5 years back and has spent more time in a bull market than a bear market. While the back-tested data suggests that it has met its objective of lower volatility over a long time period, it has yet to prove the same in real time basis. We should continue to watch this space closely to see how it weathers tougher markets before making an investment decision.