Should Nifty 50 be your only choice to play passive? What if a smarter fund can return better than the Nifty 50 or the Nifty 100, but:
- is not an active equity fund
- does not need you to take higher risk
- gives your portfolio some diversification
Yes. And these are quant or factor-based indices. While the Indian market is only just evolving to build smarter indices than the main market-cap based indices, there are already a few good options to be had.
A good index that ticks all the points above is the Nifty 100 Low Volatility 30. Constructed based on a stock’s price volatility, the index is a better performer than the parent Nifty 100. The low volatility is the key factor that helps push returns over the long term.
The year so far has seen a precipitous fall and very rapid rally. But there are concerns aplenty on corporate profitability and the economic scenario, not to mention the global risk scenario which could see more volatility ahead. In such a situation, a low volatility index can help equity participation but with more moderate risk.
The route to the Nifty 100 Low Volatility 30 is via ETFs. For this index, we recommend ICICI Prudential Nifty Low Vol 30. This ETF forms part of our Prime ETF recommended list and features in our passive portfolio in Prime Portfolios.
Built to contain volatility
The Nifty 100 Low Volatility 30 (Nifty Low Vol) draws from the Nifty 100, making it a large-cap index. The index is built using the volatility factor.
- Volatility is measured by the deviation in daily price movements for the preceding 1 year. Stocks are scored and ranked based on this volatility.
- The least 30 volatile stocks make the index. The weight of each stock to the index is based on its volatility score and not its market capitalisation.
- Weights to stocks are capped to 3% for some stocks which have lower average turnovers. Weights to other stocks are distributed proportional to their volatility score.
How does building a portfolio based on these weights help?
- For one thing, the weights to stocks are far more distributed in the Nifty Low Vol, as it does not use market capitalisation as the criteria. The top 5 stocks in the index have a combined weight of 23.6%.
In contrast, the Nifty 100 is based on the stock’s market cap which invariably sees stocks with large market cap dominating the index. The top 5 stocks in the index have a combined weight of 35.4%.
- Second, it locks into stocks with minimum price fluctuations. In periods of market correction, it helps keep losses lower as the stocks do not fall as much as the parent Nifty 100 index. For instance, in the year to date, the Nifty 100 has dropped 16% while the Nifty Low Vol 30 fell just 8%. This has been helped by 20 stocks delivering returns better than the Nifty. Stocks such as Cipla, Pidilite, and Britannia rose while others such as Infosys, TCS and Hero MotoCorp fell far lesser.
Consider the data below, which takes into account returns from different periods since the Nifty Low Vol’s April 2005 base date.
Clearly, the Nifty Low Vol contains downsides much better – it falls less frequently, and when it does, it falls lesser than the parent Nifty 100. In markets corrections such as 2008-09 and 2011, the index was better than the Nifty 100 by a solid 11 percentage points.
Of course, during bull markets, the Nifty Low Vol will tend to lag. However, in the long term, the lower volatility still helps sustain better returns – simply because smaller the loss, the quicker the recovery and lower the need for a big rally. That low volatile stocks tend to deliver better is a learning when it comes to the volatility experienced in Indian stocks.
Better returns over time
It is this factor that sets the Nifty Low Vol’s returns above the Nifty 100. The index’s ability to deliver higher returns than the Nifty 100 improves over the long term as the benefits of the lower fluctuations kick in.
Rolling 1-year returns since the 2005 base date has the Nifty Low Vol bettering the Nifty 100 65% of the time. This may not appear compelling. But stretch the period to 3 years and the index beats the Nifty 100 89% of the time. Push even longer to 5 and 7 years, and the Low Vol delivers returns higher than the Nifty 100 all the time. the margin by which it does so averages to 3.8 percentage points. Since the returns of the Nifty 100 and the Nifty 50 are very similar, the Nifty Low Vol beats the Nifty 50 too.
The Nifty Low Vol’s return deviation comes in far lower than the Nifty 100 or the Nifty 50. This lower deviation results in a better Sharpe score, which measures risk-adjusted returns. The index also has a far better Sortino ratio, which measures downside volatility.
In a nutshell, if you are looking for returns to just beat the large-cap indices, you don’t have to necessarily go for the extreme choices of midcaps or aggressive indices like the Nifty Next 50.This index will do that job and is therefore a mid-option between large-cap and aggressive indices.
How to invest
There are no index funds that currently have the Nifty Low Vol as the underlying. You can invest in this index only through the ETF route – ICICI Prudential Nifty Low Vol 30. You will need a demat and trading account in order to invest in the index.
The important metric to consider in ETFs is the tracking error – on this count, IPru Low Vol ETF does well and has a low tracking error. The ETF does not have very high trading volumes, given that it is a relatively unknown index and therefore sees limited interest. In the past six months, traded value has averaged about Rs 82 lakh. Trading may be erratic on some days, however; there have been days where traded values have been Rs 2-5 lakh. We’re still comfortable despite lower volumes as it has not impacted tracking error.
Besides, the ETF’s market price tracks the NAV on most occasions, barring exceptional periods such as the March 2020 lows and into April 2020. This deviation has now narrowed. This also means any inelasticity in demand-supply is not sharp enough to impact price.
Suitability of the Nifty Low Vol
The Nifty Low Vol 30 index is a good option for investors with a conservative to moderate risk appetite. The index’s ability to keep downsides and return fluctuations under control and its large-cap nature means that its overall risk level is on the lower side. Note the following points on incorporating this index in your portfolio:
- Allocate the index for long-term investment horizons of 5 years and above. This longer period is needed for the benefit of the low volatility to kick in.
- Use it as a portfolio diversifier. Given that the Nifty Low Vol is a factor-based quant index, it offers a strategy and sector diversification away from the Nifty 100 as well as active large-cap or multi-cap funds.
- Combine it with other active funds to build a balanced portfolio. Consider mid/small-cap active or passive options if you have a higher risk appetite.
- The one point you need to note in Nifty Low Vol is that it has low exposure of just 8.8% to banking & financial services as opposed to 32.5% in the parent index Nifty 100. This exposure may never match the parent as the low volatility criteria will keep the high volatile banking & financial sector exposure at bay. Hence, it still makes sense to combine this index with Nifty 50 or Nifty 100 or go for banking stocks if you are a stock picker. Or if you want to consciously avoid the financial space, then this index fits your bill.
- If you have a larger investment amount, spread it out over multiple days to account for the lower trading volumes in the ICICI Pru Low Vol ETF. Do so when you want to exit as well.