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Investment Strategy | How to generate alpha in stocks with lower volatility

The common belief among investors is that above-market return (alpha) on a steady basis can be generated only by taking greater risk in the long term. This prompts a lot of investors to wager on risky ‘concept’ or ‘sunrise’ stocks, as part of a diversification strategy to add ‘alpha’ and make total portfolio returns juicier. However, this strategy may work only for limited years, and is risky.

So, what is the way out to generate an above-market return without falling into the trap of risky bets? In other words, is there a way to find stocks with lower volatility, which could potentially deliver benchmark-beating returns?

Once thought to be an intractable problem for investors, one answer to it is to invest in an underlying index that is built using multi-factor strategy, which gives equal weightage to historical alpha generation capability and low volatility. This means investing in an index that is composed of stocks that have outperformed the broader market, but still are relatively less volatile.

In factor-based investing, stocks are selected based on style factors such as size, alpha, quality, value, momentum and low volatility. This approach offers benefits of both active and passive investing by applying proven stock-specific factors —such as alpha, quality — that are used in active investment as well as the rule-based framework of passive investment. When two factors are considered for the index construction, it is called a multi-factor investing technique.

Typically, the single factor-based index construction strategy shows cyclicality and underperforms in certain market phases. But multi-factor strategy mitigates the cyclical component of single-factor indices.

The Opportunity from Low-Volatility Outperformers

NSE has a strategy index called the Nifty Alpha Low Volatility 30 index, which is a multi-factor index based on the alpha and low volatility. The index captures performance of 30 stocks selected from a universe of 150 largecaps and midcaps, that have recently outperformed the broader market along with lower volatility than the benchmark index.

A stock’s outperformance is measured by Jensen’s alpha, based on the previous one-year price, while volatility is the inverse of the standard deviation of the normal daily returns for the same period. Stocks are selected based on their weighted average percentile scores, determined using an equal-weighted combination of each stock’s alpha and volatility score. The weight of each stock on the index is based on an equal-weighted combination of its alpha and volatility score and is capped at 5 per cent.

With the market at a record high, investors typically are running helter-skelter to invest in good companies and, hence, they end up investing in unproven business models in order to generate above-market returns. No wonder, the retail holding — investors with holding of up to Rs 2 lakh — reached an all-time high of 7.18 per cent in June 2021 as Fear Of Missing Out (FOMO) gradually crept in.

An investment in a strategy index like the Nifty Alpha Low Volatility 30 index offers growth with stability and lower price swings.

Alpha Low volatility index outperforms

The Nifty Alpha-Low Volatility 30 index has outperformed the Nifty50 and delivered an annual return of 20.2 per cent over the past decade, while Nifty50 has posted a return of 14.2 per cent for the same period on a total return basis. The multi-factor index, based on alpha and low volatility, has outperformed Nifty50 in eight out of the ten years till 2020. Low volatility stocks tend to outperform in the long run, as investors, over a period of time, overpay for the more exciting and choppier stocks, as their lustre fades over time.

Consequently, stocks with lower volatility on a longer-term horizon provide steadier returns. The standard deviation — a measure of risk — of the Nifty Alpha Low Volatility 30 index has been about 2 per cent lower than that of Nifty50 since its inception, adding further comfort to investors looking for lower performance swings. The Nifty Alpha Low Volatility index currently has the largest weightage on consumer goods, (40 per cent) IT (23 per cent), pharma (16.10 per cent) and chemicals (16.10 per cent). On the stock side, Dabur India with a weightage of 4.59 per cent is the largest company on the index, followed by Mindtree (4.59 per cent), Hindustan Unilever (4.37 per cent), Colgate (4.16 per cent) and Britannia (3.99 per cent). Due to the higher weightage of consumer goods in the index, the price-earnings multiple of the Nifty Alpha-Low Volatility Indez trades at 39.8 times on trailing 12 months basis, while Nifty50 trades at 26.25 times.

For an investor looking to invest in this index, there are multiple offerings in the form of ETF and FOF to choose from. Through this offering, investors will be able to get exposure to multiple factors through a single product. Those with Demat accounts can opt for the ETF option while the ones without Demat can opt for the FOF option. To conclude, this multi-factor strategy will not only aid long-term capital appreciation but can also ensure that the volatility associated is much lower, making it a win-win situation for an investor.

(Harshvardhan Roongta, CFP, is MD of Roongta Securities. Views are his own)

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