From October, however, heavy FII net selling of over ₹1.14 trillion in equities, which has continued albeit with less ferocity in November as well, resulting in steep correction in many pockets apart from declines in the frontline indices.
This is when investors realize how volatility can cause havoc to portfolios.
In the world of investing, if you extrapolate past average returns (of, say, the 2020-2024 period) into the future for planning your goals, you could end up falling way short of your requirements. For, averages don’t capture the underlying risks. When returns at various points deviate too much from the average, the portfolio is volatile.
Thus, for steady risk-adjusted returns, a portfolio that has low variance (square root of standard deviation) may just be the answer. Lower the variance in a portfolio, the steadier the risk-return rewards.
Low variance amidst heightened risk appetite
In the frenzied market rally from the March 2020 COVID lows, investors have disregarded asset allocation by skewing their portfolios almost entirely with equities (with little to no weightage to bonds and commodities (gold, silver)). Sectoral and thematic funds recorded ₹1.41 trillion in net sales over the past 12 months according to trade body AMFI’s data. Investors seem to believe that the superlative returns seen in some segments can be repeated in the future.
Valuations are in the expensive zone. Nifty 500 trades at a PE multiple of 26 times, while the Nifty Midcap 150 and Small Cap 250 indices trade at 43 and 48 times, respectively.
Liquidity also cannot be taken for granted even though domestic flows are strong. The process of allocating to other Asian markets such as Japan and heavy flows into the US markets post the presidential elections mean that foreign flows to India may not pick up soon.
Geopolitical tensions continue to escalate, and hold the potential to push up oil prices.
Government finances, however, continue to be healthy with fiscal deficit likely to halve by FY26 to 4.5% from over 9% in FY20.
Premiumization in consumption (purchase of SUVs, houses in excess of ₹1 crore etc.) continues to be intact.
On the whole, investors have tended to underplay the risk considerations mentioned earlier while overplaying the optimistic parts. This can be dangerous for investor portfolios, thus necessitating a risk-adjusted return focus.
Low variance, high rewards
Now, risk-adjusted returns come from ensuring low variance in the portfolio. For starters, large caps offer the best mode of ensuring a low volatility portfolio with predictable cash flows, reasonable valuations (especially after the recent FII sell offs), adequately strong corporate governance and high liquidity.
Instead of relying solely on a rule-based plain variance factor, incorporating active management into the filtered universe can help reduce instances of negative stock movements by considering factors like earnings outlook, management commentary, and more.
Low volatility investments can be fairly rewarding. For example, the Nifty 100 Low Volatility 30 TRI has outperformed the Nifty 100 TRI in 12 of the last 20 calendar years.
A low variance portfolio may not outperform the broader markets during frenzied rallies. But its real strength lies falling much lower than standard benchmarks during corrections.
Rolling returns also indicate the consistency in returns.
The author of this article is CA Ramesh Kr Rathi, Partner, TOPVIEW WEALTH.
NOTE: This is partnered post.
