Low Volatility Strategy: How to Navigate the Highs and Lows of the Market with a Low Volatility Strategy

Insight:

Since the start of 2022, capital markets have been quite volatile. Additionally, it rained with global macro events such as rising inflation, the Russian-Ukrainian war, China lockdown and rate hikes, which left a lot of uncertainty among market participants.

During these turbulent times, investors are often looking for investment solutions that can help reduce the heightened volatility.

The low volatility strategy:

Among several factor-based investment strategies, the low volatility factor includes stocks with historically stable price movement. Additionally, this strategy selects companies with relatively mature business models and stable earnings visibility.

Most investors suffer from loss aversion bias, which means that the pain of losing is twice as great as the pain of winning. Therefore, in times of a free fall in the market, the low volatility strategy can help reduce the magnitude of the fall. Additionally, having the support of a low volatility strategy can also minimize panic decisions made during the steep downside phase.

Recent performance of the low volatility strategy:

Let’s see how the low volatility strategy performed against the Nifty 200 (hereafter referred to as “markets”).

Exhibit-1: Performance (LHS) and Drawdown (RHS) indices as mentioned

Disclaimer/Source: MOAMC, niftyinces.com, Asia Index; Data as of July 25, 2022. The chart above is used to explain the concept and is for illustrative purposes only and should not be relied upon for the development or implementation of any investment strategy. Past performance may or may not be sustained in the future.

The YTD return of the low volatility strategy is -2.3%, while the market return is -3.3%, an outperformance of 1%. The former outperformance may not seem like much; however, the maximum drawdown the low volatility strategy faced during this period was -13% versus -16.5% of the market. This is an outperformance of 3.5%. The data puts the proof in the pudding and demonstrates that the low volatility strategy works as expected from its characteristics.

Nevertheless, it is interesting to see why the low volatility strategy falls less than the market. A quick look at the composition of the strategy will tell us which sectors/stocks have the largest representation in the strategy index.

Figure-2: Sector composition of the S&P BSE Low Volatility Index

Disclaimer/Source: S&P BSE; Data as of June 30, 2022. The areas mentioned herein are for general evaluation purposes only and not a full disclosure of all material facts. It should not be construed as investment advice to any party. Past performance may or may not be sustained in the future.

Let’s look at the main sectors by weight. Defensive sectors such as FMCG and Consumer Discretionary take the lion’s share, at 34% and 22.5%, respectively. These sectors generally show inelasticity towards high prices and are less impacted. Conversely, cyclical sectors such as industry and raw materials are absent or occupy little weight in the index, protecting it from sharp declines.

We saw above that the low volatility strategy fell less than the markets in 2022, but was this also the case during past market declines.

Turn the pages into a story

Let’s analyze how the low volatility strategy performs at different levels of market decline. Here we put the strategy to the test of time to determine if it stands out.

Exhibit-3: Drawdown analysis: 2007-2022

Source: MOAMC, niftyindices.com, S&P ESB; Data as of July 25, 2022; Markets – Nifty 200 TRI, Low Volatility – S&P BSE Low Volatility TRI The table above explains the concept, is for illustrative purposes only and should not be used to develop or implement an investment strategy. Note that the assumptions listed above are central to the illustration.

In the table above, column (B) indicates the average drawdown of the markets each time it falls by X%, i.e. mentioned in column (A). Similarly, column (C) shows the average drawdown of the low volatility strategy over the same period.

We can observe that the low volatility strategy has outperformed the broader markets with each market decline. Additionally, we see an interesting pattern that as markets go down, the outperformance of the low volatility strategy relative to the market also increases. For example, at 20% market downside, the low volatility outperformance is ~4%, but at 35% market downside, the outperformance increases to ~14%. This shows that the low volatility strategy has also performed as expected in the past.

The low volatility outperformance stems from several investor behavioral biases, such as the lottery effect, overconfidence bias and the asymmetric nature of returns.


Conclusion:

As observed above, with enough historical data and empirical evidence, we can see the presence of the low volatility anomaly in the market. The low volatility strategy exploits human behavioral biases to limit downside risk. So essentially the strategy goes down less so it doesn’t have to go up as much to outperform the markets. Exposure to such a strategy can help you

through the market falls more smoothly.

(The author, Sankaranarayanan Krishnan, is Quant Fund Manager (PMS & AIF), Motilal Oswal Asset Management Company. Opinions are his own.)