Low Volatility Technique: sail the ups and downs of market with a low volatility technique

Overview:

For the reason that begin of 2022, the capital markets have been fairly unstable. Furthermore, it has been raining with international macro-economic occasions similar to larger inflation, the Russia-Ukraine conflict, China lockdown, and charge hikes, which have left a lot uncertainty among the many market contributors.

Throughout such turbulent instances, traders typically search for funding options, which can assist scale back the heightened volatility.

The low volatility strategy:

Amongst a number of factor-based investing methods, the low volatility issue contains shares with traditionally secure worth motion.Additional, this technique selects corporations with comparatively mature enterprise fashions and secure earnings visibility.

Most traders undergo from loss aversion bias, i.e. the ache of shedding is twice as a lot because the ache of profitable. Due to this fact, in instances of market free-falls, the low volatility technique could assist to lower the magnitude of the autumn.As well as, having a low volatility technique’s help may additionally reduce the panic choices made throughout the excessive drawdown section.

Current Efficiency of the low volatility technique:

Allow us to see how the low volatility technique fared towards the Nifty 200(herewith known as “markets”).

Exhibit-1: Efficiency (LHS) and Drawdown (RHS) of indices as talked about

Disclaimer/Supply: MOAMC, niftyinces.com, Asia Index; Data as of25 July 2022.The above graph is used to elucidate the idea and is for illustration function solely and shouldn’t be used for improvement or implementation of an funding technique. Previous Efficiency could or will not be sustained in future.

The YTD returns for the low volatility technique stand at -2.3%, whereas that of the market is at -3.3%, i.e. an outperformance of 1%. The previous outperformance could not appear a lot; nevertheless,the utmost drawdown confronted by the low volatility technique throughout this time has been -13% towards -16.5% of the market.This isan outperformance of three.5%. The info places the proof within the pudding and demonstrates that the low volatility technique is performing as anticipated from its traits.

However, it’s fascinating to see why the low volatility technique falls lower than the market. A fast take a look at the technique’s composition will inform us which sectors/shares have probably the most important illustration within the technique index.

Exhibit-2: Sector Composition of S&P BSE Low volatility index

Disclaimer/Supply: S&P BSE; Knowledge as of 30 June 2022 . The sectors talked about herein are for common evaluation function solely and never an entire disclosure of each materials reality. It shouldn’t be construed as funding recommendation to any occasion. Previous Efficiency could or will not be sustained in future.

Let us take a look at the highest sectors by weight. Defensive sectors similar to FMCG and Client Discretionary occupy the lion’s share,i.e. 34% and 22.5%, respectively. These sectors typically exhibit inelasticity in the direction of excessive costs and get much less impacted.Conversely, cyclical sectors similar to industrial and commodities are absent or occupy little weight within the index defending it from steep falls.

We noticed above that the low volatility technique fell lower than the markets in 2022, however was it the case throughout the previous market falls as properly.

Turning the pages into historical past

Allow us to analyze how the low volatility technique fares throughout completely different ranges of market falls. Right here, we put the technique by means of the check of time to find out whether or not it stands out.

Exhibit-3: Drawdown Evaluation: 2007-2022

Supply: MOAMC, niftyindices.com, S&P BSE; Knowledge as of 25 July 2022; Markets – Nifty 200 TRI, Low volatility – S&P BSE Low Volatility TRI The above desk explains the idea, is for illustration functions solely, and shouldn’t be used to develop or implement an funding technique. Word that the assumptions listed above are central to the illustration.

Within the desk above, Column (B) reveals the typical drawdown of markets every time it fell by X%, i.e. talked about in column (A). Equally, column (C) reveals the typical drawdown of the low volatility technique throughout the identical interval.

We will observe that the low volatility technique outperformed the broader markets at every market fall. Additional, we see an thrilling development that as markets fall deeper, the outperformance of the low volatility technique towards the market additionally will increase. For instance, at 20% market drawdown, the outperformance by low volatility is ~4%, however at 35% market drawdown, the outperformance jumps to ~14%. Thisshows that the low volatility technique has additionally behaved as anticipated prior to now.

The low volatility outperformance stems from a number of behavioural biases of traders, such because the lottery impact, overconfidence bias and uneven nature of returns.


Conclusion:

As noticed above, with enough historic information and empirical proof, we are able to see the presence of the low volatility anomaly available in the market. The low volatility technique exploits human behavioural biases to restrict the draw back threat. So, primarily, the technique falls much less in order that it does not should rise as a lot to outperform the markets. Publicity to such a method will help you

by means of market falls extra easily.

(The writer, Sankaranarayanan Krishnan, is Quant Fund Supervisor (PMS & AIF), Motilal Oswal Asset Administration Firm. The views are his personal.)