RETAIL investors who want downside protection during market corrections can opt for low volatility funds that fund houses are offering. These funds are low-cost passive mutual funds that track the low-volatility indices of stock exchanges. The composition is based on the methodology that has different criteria for the selection of the stocks from their respective universe.
Low volatility funds predominantly have large-cap companies hence making it an investment option for investors who want to invest in relatively stable companies with lesser volatility and the portfolio rebalancing is done every quarter. Low volatility funds typically invest in stocks that have generated better risk adjusted returns over recent time periods such as one year or so. In other words, such stocks would have generated better Alpha over other stocks with lower volatility or standard deviation.
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Typically, such funds passively track a specific low volatility index created by an index provider. Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says these indexes typically invest in around 30 stocks consisting primarily of large-cap stocks with limited allocations to mid and small cap stocks. “The index is rebalanced on a specified frequency, typically semi-annual to identify stocks meeting the criteria laid down by the index provider. The methodology tends to be quant based with certain restrictions on number stocks or maximum weight to each stock, etc,” he says.
Low volatility funds can provide stability to an investor’s portfolio. Mayur Shah, PMS fund manager, Anand Rathi Advisors, says it is like an investor who chooses to invest in all three caps – large-cap, mid-cap and small-cap funds or multi-cap/ flexi-cap fund where fund manager tries to bring stability in portfolio and also ensure that the growth momentum is maintained. “Investors can understand the importance of low volatility funds when there is a consolidation or a correction in the market,” he says.
What to keep in mind
In equity, investors cannot avoid volatility. However, the passive low volatility funds are less volatile as compared to active funds. Harshad Chetanwala, co-founder, MyWealthGrowth.com, says there are other factors like the quality of the companies, their potential to deliver returns over the long term, growth prospects of the sector and overall market conditions that an investor must consider before investing in a low volatility fund. “A better portfolio could be created considering all these factors collectively. Hence, it is better to invest in a blend of active and passive funds for better growth opportunities,” he says.
The ideal factor to consider before investing in such funds is to check the tracking errors which indicate what percentage of the portfolio deviated from the fund’s benchmark and a lower tracking error is considered better. Manish P Hinger, founder, Fintoo, an investment advisory firm, says, it is important to look at the portfolio construction mechanism which should ideally select stocks with least volatility and any deviation from the said mechanism should be taken into account.
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“Having said that, investors who are planning to take exposure in relatively stable companies with low volatility within the universe of the Nifty 100 Index should ensure that they have a high-risk appetite, a long investment horizon to sustain market volatility, and an investment objective that aligns with the fund,” he says.
Risk adjusted returns
The investment objective of such low volatility schemes is to replicate the Nifty100 Low Volatility 30 index by investing in stocks or securities which are the constituents of the Nifty100 Low Volatility 30 index in the same proportion or weightage and aim in providing returns that closely correspond to the total return of Nifty100 Low Volatility 30 Index, subject to tracking errors.
These funds may offer returns closer to the Index or sometimes may underperform the Index too, as low volatility may not necessarily mean higher returns. “Like other passively managed funds, these funds can offer stability when the portfolio has a mix of active and passive funds,” says Chetanwala.
Long-term investors should always stick to their asset allocation between debt and equity. Also within equity, investors need to stick to their asset allocation between large, mid, small or flexi-cap as they are aligned to the long-term objective being set. Shah says adding more downside protection through low volatility investing is like timing the market which has not helped long-term investors.
* Importance of low volatility funds is seen in times of consolidation or correction in the market
* Such funds passively track a specific low volatility index created by an index provider
* Investment objective of such low volatility schemes is to replicate the Nifty100 Low Volatility 30 index
* These funds may underperform the Index too as low volatility may not necessarily mean higher returns