Modern finance is built on the link between risk and return. Risk is defined as the possibility of not getting back the money invested. Traditional finance gurus frequently discuss the commonly held belief that higher risk yields higher returns, i.e., higher volatility stocks provide investors with larger returns over time. However, evidence from Indian equity markets over the last two decades has painted a rather discordant image.
The finding that low-volatility stocks beat high-volatility equities has gotten a lot of attention recently, especially since the Covid-19 pandemic broke out. Low-volatility equities, or those that move less over time and have lower variation, deliver superior risk-adjusted returns to investors over time.
Low-volatility equities are chosen to limit investor losses while yet allowing for upside potential during market downturns. They’ve demonstrated their ability to surpass their peers over long periods. While high-volatility equities might produce outstanding results for a short period, lower-volatility stocks have traditionally produced greater risk-adjusted returns over time.
Why do low-volatility stocks perform better?
The phenomenal rise of the Indian stock market has been accompanied by a boom in low-risk/high-return investment methods among both domestic and international investors over the last two decades.
There are several other reasons why low-volatility equities outperform high-volatility stocks in India over time. One of the main reasons is the scarcity of high-quality, long-term, stable, and liquid equities. The Indian stock market contains around 8,000 equities, with barely 10-15% of them being liquid. Only about 100 of these equities are of good quality and long-term viability.
Low volatility enhances a company’s access to money, hence less volatile equities usually have better operating results. Large, mid, and small-cap stocks make up the stock market. The large-cap group contains the majority of the safe stocks, which are normally in high demand all of the time, but during a financial crisis, when small and mid-cap stocks perform poorly, they are in high demand.
Despite its general volatility, the presence of a volatility anomaly provides the potential to achieve significant risk-adjusted returns. When we invest in such equities for a long time, the volatility is smoothed out, and we can receive high average returns while taking on less implicit risk.
A few characteristics can be used to identify low volatility equities. After examining the group of companies for which we consistently observe low volatility and high returns, we discover that the majority of them are non-PSU stocks with strong fundamentals and high quality (small or large), i.e., high profitability ratio, stable free cash flows, high ROCE (Return on Capital Employed), low debt-to-equity ratio, high promoters’ holding, and so on.
The volatility anomaly, and hence the risk-adjusted expected return trend, are critical indicators for both investors and monetary policymakers.
For a better knowledge of the features and average return yield of low volatility stocks, investors can look at the member stocks of the Nifty 100 Low Volatility 30 Index on the National Stock Exchange website, omitting PSU stocks.