Should you invest in low-volatility funds amid high market volatility?

The stock markets have been experiencing heightened volatility amid selling by foreign portfolio investors, downgrades to corporate earnings, and slower economic growth. The Nifty 50 has corrected over 10% since 27 September.

Low-volatility funds aim to reduce the impact of market volatility by investing in a basket of stocks that tend to be less volatile. These are passive funds that track low-volatile indices. The funds invest in stocks included in a low-volatility index, which picks stocks on the basis of volatility scores rather than business fundamentals. Volatility is calculated as the standard deviation of daily price returns for the past one year.

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Performance

In the recent market scenario, funds tracking the Nifty 100 Low Volatility 30 have beaten the Nifty 50 in six-month and one-year periods. The low-volatility funds have delivered 6% returns in a six-month period, while the Nifty 50 has delivered 4% returns. The Nifty 100 Low Volatility 30 has delivered 22% returns in a one-year period, beating the Nifty 50's 19% returns.

“The low-volatility strategy tends to do well when markets are volatile or flat. However, when markets are bullish, these strategies tend to underperform significantly,” said Kavitha Menon, founder of Probitus Wealth.

“Investors can use low-volatile strategies in conjunction with other strategies such as momentum,” she added.

Consider these examples of how a low-volatility strategy played out in flat or choppy markets. 

During the global financial crisis of 2008, when the Nifty 50 index plunged 56.2% and the Nifty 100 lost 58%, the Nifty 100 Low Volatility 30 index fell 46.2%.

When the markets were flat and sideways during the US' 2013 taper tantrums, the Nifty 100 Low Volatility 30 index was down 7.7%, while the Nifty 50 was down 8% and the Nifty 100 lost 9.3%.

More recently, when the markets crashed during covid, the Nifty 50 fell 37.23% in a month and the Nifty 100 shed 36.97%, while the Nifty 100 Low Volatility 30 index lost 29.4%.

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A low volatility index typically has exposure to defensive and consumer-oriented sectors over cyclical sectors and volatile stocks. The Nifty 100 Low Volatility index has 18.46% exposure to fast-moving consumer goods (FMCG) stocks and 17.4% exposure to the healthcare sector.

Over a 1-year period, the index has a beta of 0.7, and 0.75 over a 5-year stretch. Beta is a measure of volatility in relation to the overall stock market. A reading under 1 indicates that the index will shed fewer points when the Nifty 50 corrects. But it also means that the low volatility index will gain lesser than the Nifty when the market benchmark rebounds.

“Momentum strategy will help investors keep in touch with that side of the market, which is outperforming, doing well, while the low-volatility basket will help the investor ensure a certain part of their portfolio remains less volatile," said Anish Teli, managing partner of QED Capital Advisors.

Know your universe

When investing in low-volatility indices, remember that the index focuses on large-caps or top 100 stocks in terms of market capitalization, and within that it is constructed on the basis of the least volatile stocks. This helps the index keep its volatility on the lower side. 

However, a momentum fund is likely to have exposure to mid-cap stocks. Its universe is going to be much wider, such as the top 250 or 200 stocks in terms of market capitalization, and within that, a basket of 30 stocks that rank high on momentum scores is created. 

Hence, when creating a mix of strategies, investors should understand which market segment the fund focuses on and how it affects the risk profile of the overall investment portfolio.

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