Low Volatility Index Funds: Your Friend During Market Volatility?

When you are into white water rafting, you would expect rapids, turbulent water and steep drops. Similarly, when investing in the markets, you have to deal with market volatility.

There are several strategies to deal with market volatility. There are also funds which are designed to do that.

Low volatility funds, which are index funds, are part of product innovation introduced in India over the past couple of years but have been around for more than a decade in developed markets like the USA.

“The best way to understand them is to look at active and passive funds as spectrum ends and low volatility index funds with somewhere in between. They track an underlying index but have an added filter of low volatility (defined by Beta),” says Devam Sardana, Business Head, Lemonn, an investment platform.  

Low volatility index funds track an index that selects securities that historically have experienced lesser price fluctuation compared to overall equity markets. These funds mainly track the Nifty 100 Low Volatility 30 TRI which aims to track the performance of low volatility securities among the large market capitalisation segment.

“Studies have shown that stocks with lower price volatility, often tend to outperform the broader equity market,” says Sirshendu Basu, Head, Products, Bandhan Asset Management Company (AMC). The AMC offers the Bandhan Nifty100 Low Volatility 30 Index Fund.

The above phenomenon is known as the low volatility anomaly, and contradicts the traditional belief that higher risk leads to higher returns. Investor behavioural biases, such as the tendency to overvalue attention-grabbing stocks, contribute to this anomaly.

“During market declines, low volatility strategies typically experience smaller losses, which means investors have less ground to cover to breakeven. For example, a Rs 1,00,000 lakh investment that falls by 20 per cent has to rise by 25 per cent to reach its initial level, however had the investment fallen by 50 per cent, it would necessitate a 100 per cent rise,” says Basu.

Low Volatility Funds Performance
Normally, as the name suggests, low volatility funds serve as a broad-based index that gives investors exposure to stable companies and helps them to sustain the volatility.

“The objective of the low volatility factor is to minimise the impact during market downturn and also minimise the performance drag caused by volatility. This will help investors to achieve their long-term capital appreciation,” says Satish Dondapati, Vice-President and Fund Manager, Kotak Mutual Fund. The fund house recently launched the Kotak NIFTY 100 Low Volatility 30 Index Fund.

However, there is something one should take note of. “Upon analysing the performance of the Nifty 100 Low Volatility 30 Index across different market cycles, it can be noted that typically it outperforms the broader index during bear market periods, while it majorly underperforms during bull market and recovery periods,” says Basu. 

How The Low Volatility Index Has Performed? 

Source:NSE. Data as of 01st April 2005 to 30th April 2024. Performance results may have inherent limitations, and no representation is made that any investor will or is likely to achieve. Past performance may or may not be sustained in the future.

Upon close observation, one may notice that during the bear market, the low volatility index has outperformed the Nifty 50 by ~10% across periods. Conversely, it underperforms by a similar margin during the bull and recovery phases. Says Saradana, “Low volatility index funds may not give you the exact same returns as the underlying index and they might lead to dissatisfaction in the bull run if not understood clearly (this depends on stock picking).”

However, over a long term these funds can perform better. “As previously explained, an investment that falls by a larger percentage must rise by an even larger percentage to return to the initial level. In this case, the Nifty 50 does not adequately compensate for the losses experienced during the bear market, resulting in long-term outperformance of the Nifty 100 Low Volatility Index,” says Basu.

Your Investment Strategy
“Low volatility will help investors get better risk adjusted returns along with lesser volatility. This strategy helps to temper the volatility in portfolios, allowing investors to stay invested in volatile markets,” says Dondapati.

Investors often take on more risk than they can comfortably manage. To mitigate this risk, they can consider investing in a low volatility portfolio, which helps reduce risk while still having the potential to outperform the market.

“One effective approach is the core-satellite approach, where the low volatility strategy serves as the satellite portion of the portfolio. Investors can consider allocating between 10-30 per cent of their overall equity portion to a low volatility strategy, depending on their individual risk tolerance and investment goals,” says Basu.

Low volatility funds offer a smoother ride during market dips, but sacrifice some gains in bull runs. Consider them for a portion of your portfolio to manage risk and potentially achieve better long-term returns.