By Malvika Saraf and Parthajit Kayal
The relationship between risk and returns lies at the heart of modern finance. Risk is nothing but the uncertainty of getting back the money (or even more) one invests. Traditional finance gurus often talk about the widely prevalent notion that higher risk generates higher returns, i.e., higher volatility stocks yield higher returns over time for investors. But evidence from Indian equity markets has presented quite a contradictory picture in the last two decades.
What are low volatility stocks?
The observation that low-volatility stocks outperform the high-volatility ones has received considerable attention in recent times, especially since the onset of the Covid-19 pandemic. More specifically, low-volatility stocks, i.e., stocks which fluctuate less over time and have lower variance, are the ones that provide higher risk-adjusted returns to the investors in the long run. This long-term risk-return relationship is also known as the volatility anomaly.
Low-volatility stocks are curated to limit investor losses during periods of market crisis while still allowing for an upside. They have proven their ability to outperform their benchmarks over long time periods. While high-volatility stocks may showcase impressive performance temporarily, lower-volatility stocks have proved historically generated better risk-adjusted returns over time.
Why low volatility stocks perform better?
Over the past two decades, the stupendous growth of the Indian stock market has been accompanied by a surge in low-risk/high-return investment strategies by both domestic and international investors. Since modern investors are primarily concerned about risk-adjusted returns, the bonus from the low-risk/high-return strategies are attributable to the compounding effect—the lower volatility pressure on investment returns enhances the performance of less volatile stocks. The real benefit to possessing low-volatility stocks accrues over longer periods of time, as the well-known power of compounding suggests.
There are several other reasons why low-volatility stocks perform better over time in India. An integral reason is the limited availability of quality, sustainable, stable, and liquid stocks. The Indian stock market has approximately 8,000 stocks, out of which only 10-15% are purely liquid stocks. Out of these, only around 100 stocks are of high quality and sustainability. A lot of companies get listed on the stock exchange every year but a majority of them get bankrupt, go out of business or exit the market after a decade or so. Low volatility stocks are truly sustainable stocks that possess a consistently growing staple business over a very long run. Hence retail as well as institutional investors prefer to invest only in these stocks.
They are safe stocks in the sense that they are less volatile and yield decent and consistent returns over longer periods of time. Less volatile stocks generally exhibit strong operating performance as low volatility improves a firm’s access to capital. The equity market is divided into large, mid and small cap stocks. Most of the safe stocks lie in the large cap category. These stocks are usually always in demand whereas during a financial crisis, when small and mid-cap stocks perform poorly, they tend to be in excess demand. Despite its overall volatile nature, there is an opportunity to generate high risk-adjusted returns due to the existence of volatility anomaly. When we invest in such stocks over a long period of timw, this volatility is smoothened out, and high average returns are earned by bearing lower implicit risk.
How to identify low volatility stocks?
Low volatility stocks can be identified based on a few criteria. After scrutinising the set of companies for which we consistently observe low volatility and high returns, we find that most of the companies are non-PSU stocks with strong fundamentals and of high quality (irrespective of small or large), i.e., high profitability ratio, stable free cash flows, high ROCE (Return on Capital Employed), low debt-to equity ratio, high level of promoters’ holding, etc.
The volatility anomaly and thereby risk-adjusted expected return trend are extremely important both for investors making investment decisions and monetary policy makers. Investors can look at the constituent stocks of the Nifty 100 Low Volatility 30 Index on National Stock Exchange website, excluding PSU stocks, for a better understanding of the features and average 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