Designing low-volatility strategies

Business Line recently carried an interesting analysis that showed that mid-cap and small-cap funds performed better than large-cap funds during the last six months. The period of the study is, perhaps, too short to draw an obvious conclusion.

It, however, raises interesting questions: Did mid-caps and small-caps perform better than large-caps because they were less volatile? And if so, can investors use this information to create low volatility strategies?

This article discusses the impact of volatility on portfolio returns and explains the significance of setting up low volatility strategy. It then shows how investors can create such a portfolio within the core-satellite framework.

Volatility factor

Volatility drags portfolio returns. Suffice it to know that if market follows normal distribution, the compounded annual return of a portfolio reduces as volatility increases. Specifically, the return reduces by 50 per cent of the portfolio's variance!

If volatility drags returns, high volatility stocks ought to underperform the market. And since 2008, volatility of the Nifty Index was higher than the volatility of the CNX Mid-cap Index.

This, perhaps, explains why mid-cap and small-cap funds have performed better than large-cap funds, though the observation seems counterintuitive; for large-caps are typically known to have lower volatility than mid-caps and small-caps.

Investor behaviour since 2008 can, perhaps, explain the higher volatility of large-cap stocks. The economic outlook was negative after the sub-prime crisis in 2008. This could have prompted investors to take supposedly “safe” bets — invest in large companies, as their earnings are typically considered to be more stable than smaller companies.

Between January 2008 and December 2010, large-cap stocks generated four times more returns than mid-caps. The increase in prices eventually led to increase in volatility, as all these stocks gave back nearly a fifth of their gains since January 2011. It is moot how volatility would affect returns on large-cap stocks going forward.

An optimal investment would be to select stocks that have low volatility. Of course, choosing such stocks would a challenge, as the task would also require not to give-up significant upside potential. The question is: How should investors set-up such low volatility strategies?

Low volatility strategy

The objective is to choose stocks that can perform well during volatile markets. A low volatility strategy should, hence, go beyond merely picking stocks of large companies; for stocks of such companies are not necessarily less volatile.

The first level of screening, hence, involves picking stocks of companies that have stable financial health.

This could be based on three ratios— low financial leverage, low earnings volatility and high return on assets— measured over at least five years.

This creates a universe of companies that has high quality of financial health. The second level of screening involves capturing price volatility of the stock of these companies. '

This can be captured using standard deviation of the stock based on its weekly returns during the last one year.

An investable universe is formed comprising companies that have high financial stability and low stock price volatility. This universe carries both large-caps and mid-cap stocks.

A portfolio should be created from the investable universe. Such a portfolio could serve the twin objective of having low volatility and handsome upside potential. How?

Such companies ought to face economic turbulence better than their peers due to high earnings quality. This provides scope for sizable upside potential during volatile markets, as investors seek “flight to quality” within the equity market. Of course, these stocks would underperform their volatile counterparts if the economy is vibrant and the stock market moves up.

Conclusion

Low volatility strategy seeks to generate handsome upside during volatile markets, as investors seek “flight to quality”. Stocks that carry low volatility are called ‘defensives' and should typically form part of the core equity portfolio.

On the other side of the volatility spectrum in the equity market are the ‘non-defensives' that perform well during vibrant market conditions but carry high downside.

Investors using the core-satellite approach to investing can consider non-defensives as part of their satellite portfolio; for such stocks can be used for market timing strategy.