By Malvika Saraf and Parthajit Kayal
The relationship involving danger and returns lies at the heart of contemporary finance. Risk is practically nothing but the uncertainty of having back the cash (or even more) one invests. Traditional finance gurus typically speak about the extensively prevalent notion that larger danger generates larger returns, i.e., larger volatility stocks yield larger returns more than time for investors. But proof from Indian equity markets has presented really a contradictory image in the last two decades.
What are low volatility stocks?
The observation that low-volatility stocks outperform the higher-volatility ones has received considerable consideration in current instances, in particular considering that the onset of the Covid-19 pandemic. More especially, low-volatility stocks, i.e., stocks which fluctuate much less more than time and have reduced variance, are the ones that provide larger danger-adjusted returns to the investors in the lengthy run. This lengthy-term danger-return relationship is also identified as the volatility anomaly.
Low-volatility stocks are curated to limit investor losses throughout periods of industry crisis although nevertheless enabling for an upside. They have confirmed their potential to outperform their benchmarks more than lengthy time periods. While higher-volatility stocks might showcase impressive functionality temporarily, reduced-volatility stocks have proved historically generated greater danger-adjusted returns more than time.
Why low volatility stocks carry out greater?
Over the previous two decades, the stupendous development of the Indian stock industry has been accompanied by a surge in low-danger/higher-return investment techniques by each domestic and international investors. Since contemporary investors are mainly concerned about danger-adjusted returns, the bonus from the low-danger/higher-return techniques are attributable to the compounding effect—the reduced volatility stress on investment returns enhances the functionality of much less volatile stocks. The genuine advantage to possessing low-volatility stocks accrues more than longer periods of time, as the nicely-identified energy of compounding suggests.
There are various other causes why low-volatility stocks carry out greater more than time in India. An integral explanation is the restricted availability of good quality, sustainable, steady, and liquid stocks. The Indian stock industry has around 8,000 stocks, out of which only 10-15% are purely liquid stocks. Out of these, only about one hundred stocks are of higher good quality and sustainability. A lot of firms get listed on the stock exchange just about every year but a majority of them get bankrupt, go out of organization or exit the industry just after a decade or so. Low volatility stocks are genuinely sustainable stocks that possess a regularly developing staple organization more than a pretty lengthy run. Hence retail as nicely as institutional investors choose to invest only in these stocks.
They are secure stocks in the sense that they are much less volatile and yield decent and constant returns more than longer periods of time. Less volatile stocks commonly exhibit powerful operating functionality as low volatility improves a firm’s access to capital. The equity industry is divided into substantial, mid and little cap stocks. Most of the secure stocks lie in the substantial cap category. These stocks are ordinarily normally in demand whereas throughout a monetary crisis, when little and mid-cap stocks carry out poorly, they have a tendency to be in excess demand. Despite its general volatile nature, there is an chance to create higher danger-adjusted returns due to the existence of volatility anomaly. When we invest in such stocks more than a lengthy period of timw, this volatility is smoothened out, and higher typical returns are earned by bearing reduced implicit danger.
How to recognize low volatility stocks?
Low volatility stocks can be identified based on a couple of criteria. After scrutinising the set of firms for which we regularly observe low volatility and higher returns, we uncover that most of the firms are non-PSU stocks with powerful fundamentals and of higher good quality (irrespective of little or substantial), i.e., higher profitability ratio, steady absolutely free money flows, higher ROCE (Return on Capital Employed), low debt-to equity ratio, higher level of promoters’ holding, and so forth.
The volatility anomaly and thereby danger-adjusted anticipated return trend are really essential each for investors generating investment choices and monetary policy makers. Investors can look at the constituent stocks of the Nifty one hundred Low Volatility 30 Index on National Stock Exchange internet site, excluding PSU stocks, for a greater understanding of the features and typical return yield of low volatility stocks.
Malvika Saraf is a graduate from Madras School of Economics. Parthajit Kayal is assistant professor, Madras School of Economics