Does Low Volatility Investing beat Nifty and Sensex?

Risk and Reward go hand in hand.

Higher the risk, greater the reward.

So, if you are looking for higher returns, you just need to load up on risk. At least, that’s what the Capital Asset Pricing model (CAPM) used to calculate expected stock returns tells us.  

However, the experience has been completely different in various markets. Low volatility stocks have outperformed more volatile stocks over the long term.

How has the experience been in India?

Has Low Volatility investing been delivered better returns than benchmark indices such as Nifty and Sensex? By virtue of their construct, you can expect such indices/stocks to have done better (lower) volatility than Nifty or Sensex. Therefore, even if the low volatility stocks/indices can offer the same level of returns at lower volatility, you will earn better risk-adjusted returns.

Let’s find out.

Low Volatility Investing: What do we compare?

We use the Total Return Indices (dividends included) for the following 4 indices.

1. Nifty 50
2. Nifty 100 Low Volatility 30: The NIFTY100 Low Volatility 30 index tracks the performance of 30 stocks in NIFTY 100 with the lowest volatility in the last one year. Weights of securities in the index are assigned based on the volatility values. The security with the lowest volatility in the index is assigned the highest weight.
3. Nifty Low Volatility 50 Index:  NIFTY Low Volatility 50 Index tracks the performance of the least volatile securities listed on NSE. Weights of securities in the index are assigned based on the volatility values. The least volatile security in the index gets the highest weight.
4. Nifty High Beta 50 Index: NIFTY High Beta Index tracks the performance of 50 stocks with the highest Beta in the last one year. Weights of securities in the index are assigned based on the beta values. The security with the highest beta in the index is assigned the highest weight.

You can read about the methodology in detail on NiftyIndices website.

We have a bellwether index in Nifty. We have a couple of low volatility indices and a high beta index.

While Beta is not the perfect indicator of absolute volatility, it is an indicator of volatility in relation to the market and should be good enough to drive home the point in this exercise. The market has a beta of 1. If the beta of a stock or a fund portfolio is greater than 1, the stock/fund is more volatile than the market and vice-versa.

We compare the performance from April 1, 2005 until August 21, 2020.

Nifty High Beta 50 Index was launched in November 2012.

Nifty 100 Low Volatility 30 index was launched in July 2016.

Nifty Low Volatility 50 index was launched in November 2012.

Therefore, the data prior to the respective launch dates is back-tested. You must take back-tested data with a pinch of salt.

By the way, low volatility is just of the investment factors. For more on factor investing, what are the different factors (value, momentum, low volatility, quality, etc), and how these factor investments have performed in the past, refer to this post.

Performance Comparison: Low Volatility vs. High Volatility

Let us first consider the lumpsum investment on April 1, 2005.

The performance of the Nifty High Beta 50 index is strikingly bad. High beta investing seems like a complete failure even in the back-test.

Nifty 50 TRI grows to 668.22. CAGR of 13.7% p.a.

Nifty High Beta 50 Index grows to 111.96. CAGR of 0.7% p.a.

Nifty 100 Low Volatility 30 grows to 1,193.62. CAGR of 17.5% p.a.

Nifty Low Volatility 50 grows to 1,195.81. CAGR of 17.5% p.a.

High Beta investing has been a disaster.

The low volatility indices have done much better than Nifty 50 TRI.

The performance of Nifty 100 Low Volatility 30 index and Nifty Low Volatility 50 index is similar on most parameters (and not just the lumpsum investment).

Nifty 50: Best performing in 2 years. Worst performing in 3 years.

Nifty High Beta 50: Best performing in 4 years. Worst performing in 11 years. Wow!

Nifty 100 Low Volatility 30: Best performing in 5 years. Worst performing in 2 years.

Nifty Low Volatility 50: Best performing in 5 years. Worst performing in none of the years.

Performance Comparison: Rolling Returns

Let us look at 3-year and 5-year rolling returns.

Both the Low volatility indices have done better than Nifty 50 index.

Nifty High Beta 50 is painful. Even over the long investment horizons, you would have lost money.

What about Volatility and drawdowns?

You will expect the Low Volatility indices to have low volatility and the High Beta index to be more volatile. After all, that is the basis of these indices.

This relationship holds along the expected lines.

Coming to drawdowns, the less we speak the high beta index, the better. What a disaster!!!

The Low Volatility indices have been able to manage drawdowns quite well. The drawdown is lower than the Nifty 50 almost all the time. Quite impressive.

In my opinion, the lower drawdown is the primary reason why the Nifty 100 Low Volatility 30 and Nifty Low Volatility 50 have beaten Nifty 50 on all the parameters.

In the 4 calendar years (current included) Nifty 50 TRI has given negative returns (2008, 2011, 2015, and 2020 (until August 20)), both the low volatility indices have beaten the Nifty massively.

Points to Note

1. The past performance may not repeat. Low volatility investing may not give better returns in the future.
2. I have used the results of the total returns index (TRI). Actual returns will be different because of expenses and the tracking error.
3. There is no guarantee that Low volatility indices will give better returns than plain-vanilla market cap-weighted indices such as Nifty and Sensex.
4. Much of the data considered for Low volatility indices is back-tested. You can expect back-test results to be good, otherwise, the index won’t be launched.
5. The returns of an investment strategy may come down when more money chases it.

What should you do?

We have seen above that low volatility indices have performed better than Nifty 50.

There is an ETF by ICICI Prudential AMC tracking Nifty 100 Low Volatility 30 index. It was launched in July 2017. If you see merit in low volatility investing, you can consider investing in this ETF. In April 2021, the AMC has also launched ICICI Prudential Nifty Low Vol 30 FoF. This FoF will invest in the aforesaid ETF.

So, if you want to invest in low volatility stocks and don’t have a demat account (or do not want to trade and navigate Price-NAV issues in ETF), you can invest in FoF. If you have the conviction about the merits of low volatility investments, you can consider such investments as a replacement for your actively managed large-cap funds.

Please understand this is NOT a recommendation to invest in this ETF or FoF.

Remember, no strategy, no matter how good, works all the time. You must have the patience and the ability to accept that this can backfire. There is no guarantee that low volatility indices will beat the Nifty 50 in the future.

Fortunately, there is no index fund for Nifty High Beta 50 Index fund. In any case, you must avoid this index.

A Note on Nifty High Beta 50 Index

While we can debate about the best performing index, there is no confusion about the worst performing index. Nifty High Beta 50 index has delivered the worst lumpsum returns. It is the worst performer on 3-year and 5-year rolling returns. Not just that, it has delivered such poor returns with the highest volatility and the deepest drawdowns. Bad on every possible criterion. Hence, it should be easy to avoid such an investment strategy. Well, not so simple.

Despite such a poor performance, it has been the best performing index (out of the 4 indices considered) in 4 out of 14 completed years (2007, 2009, 2012, 2017). It was a close second in 2014. This statistic is not bad per se. This is an example of: No strategy, no matter how bad it is, fails all the time. And therein lies the trap.

If you look at just the recent past performance of stocks/funds, you can get sucked into such stocks or the style of investing. While I have not verified this, this (good performance of High Beta) is likely to be around the time when small-cap stocks (or small-cap index) have done very well.

You can also look at the recent stock market meltdown in March 2020.

From Feb 1, 2020 until March 23, 2020, Nifty High Beta lost 46.7%. Nifty 50 (34.6%). Nifty 100 Low Volatility 50 (27.2%). Nifty Low Volatility 50 (26.4%)

Since March 23, 2020, the Nifty High Beta Index is up 64% (as on August 21, 2020). Nifty 50 TRI is up 50.2%. Nifty 100 Low Volatility 30 (47.5%). Nifty Low Volatility 50 (46.5%).

A friend of good times if there was one.

No need to rejoice. It will kill you during bad times.

Just look at the quantum of negative returns in bad times for the index.

2009 (-68.5%)

2011 (-52.49)

2013 (-18.94%)

2015 (-16.62%)

2018 (-27.37%)

2019 (-17.76%)

2020 (until August 20): -15.84%

You cannot lose money so frequently and still come out on top. The key to investment success is to lose less.

When you lose 20%, you need to earn 25% (on the depleted capital) just to break even.

When you lose 50%, you need to earn 100% to break even.

Such stocks or indices must be strictly avoided.

I am glad that there is no index fund replicating the performance of this index. Do not expect such a product anytime soon either. It will be foolish to launch one.

However, don’t many of us invest in this manner?

Don’t we get attracted to markets when the markets are roaring? And now we know, what kind of stocks of funds must be doing very well around that time? If such investors look at the performance of just the past few months, they will pick up the wrong kind of stocks or funds. Wealth destruction and disillusionment with the equity markets will follow.

Test Results of other Investment Strategies

Over the past few months, we have tested various investment strategies or ideas and compared the performance against the Buy-and-Hold Nifty 50 portfolio. In some of the previous posts, we have:

1. Discussed How to reduce portfolio losses?
2. Assessed whether adding an International Equity Fund and Gold to an Equity portfolio has improved returns and reduced volatility.
3. Does Momentum Investing work in India?
4. Does Low Volatility investing beat Nifty and Sensex?
5. Which is the best date for SIP in mutual funds?
6. Performance Comparison: Investing on 52-week Lows vs Investing on 52-week Highs
7. UTI Nifty 200 Momentum 30 Index Fund: Performance Review
8. Nifty Factor Indices (Value, Momentum, Quality, Low Volatility, Alpha): Performance Comparison
9. Nifty Alpha Low Volatility 30: Performance Review
10. 50% Gold + 50% Equity: How does the portfolio perform?
11. What is the Best Asset Allocation for your portfolio? 50:50, 60:40 or 70:30?
12. Considered the data for the past 20 years to see if the Price-Earnings (PE) multiple tells us anything about the prospective returns. It does, or at least has in the past.
13. Tested a momentum strategy to shift between Nifty 50 and a liquid fund and compared the performance against a simple 50:50 annual rebalanced portfolio of Nifty index fund and liquid fund.
14. Used a Simple Moving Average Based Market Entry and Exit Strategy and compared the performance against Buy-and-Hold Nifty 50 over the last two decades.
15. Compared the performance of Nifty Next 50 against Nifty 50 over the last two decades.
16. Compared the performance of Nifty 50 Equal Weight vs Nifty 50 vs Nifty 50 over the last 20 years.
17. Nothing works all the time. Used Nifty 50, Nifty MidCap 150, and Nifty Small Cap 250 index to demonstrate that sometimes intuitive investment choices do not work.
18. Compared the performance of 2 popular balanced funds against a simple combination of an index fund and a liquid fund.
19. Compared the performance of a popular dynamic asset allocation fund (Balanced advantage fund) against an equity index fund and see if it has been able to provide reasonable returns at low volatility.
20. Nifty 50 vs Portfolio of Pharma + Banking + IT stocks: Which is better?

Additional Links

Nifty 100 Low Volatility 30 Index

Nifty Low Volatility 50 Index

Nifty High Beta 50 Index

The Less understood Relationship between Risk and Reward