The Mutual Fund Show: Is A Low-Volatility Fund Of Funds Worth Investing?
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The Mutual Fund Show: Is A Low-Volatility Fund Of Funds Worth Investing?

Last year, when stock traders had a roller-coaster ride, from the coronavirus pandemic-triggered selloff in equities to scaling new peaks, the Nifty Low Volatility 30 Index outperformed its benchmark.

The gauge tracking the performance of 30 stocks in the Nifty 100 with the lowest volatility in the last one year was launched in July 2016. ICICI Prudential Asset Management Co. launched an exchange-traded fund replicating the index a year later. But as an ETF can’t be bought by investors who don’t have a demat account, the asset manager has now launched a fund of funds that invests in the ETF.

The whole idea or concept of low volatility itself is very appealing for two reasons—stability and diversification, according to Chintan Haria, head product and strategy at ICICI Prudential AMC. If investors get a product where a fund manager can choose 30 stocks, out of a universe of the top 100 stocks, thus giving good diversification and more stability because of less volatility, then it could be a win-win for them, he said on BloombergQuint’s weekly special series The Mutual Fund Show.

“We all know that risk-adjusted return is something which international investors look upon a lot and even in India it’s gaining ground,” he said. “A large set of Indian investors are looking at low volatility 30 ETF because on a risk-adjusted returns parameter, it does provide a better return.”

Haria, however, highlighted that this particular portfolio may underperform when the market changes direction in favour of high-volatility stocks. Besides, the “necessary risk of equity” is there. “If the entire market itself falls, then this being equity will fall too.”

According to Kirtan Shah, chief executive officer at Ambition Learning Solutions, because this is a low-volatility product, it’s been able to protect the downside. The index can also outperform in good times. This, he said, is meant for somebody who wants low volatility in their portfolio, but someone who is ready for a higher risk-based return may not find this product favourable.

Ambition Learning has been recommending Parag Parikh Flexicap Fund to its clients. Shah said this scheme follows a bottom-up stock-picking strategy and employs time-tested principles of value investing. Starting from the inception date, with a three-year holding period, the fund has never delivered negative returns, Shah said, adding the lowest return for the three-year holding period is 0.07% (annualised).

According to Shah, the scheme benefits on account of:

  • Geographical diversification, as the scheme invests only 65% of the portfolio in Indian stocks.
  • Risk-adjusted returns, as the scheme is not exposed to single-country risk.
  • Low currency risk, as the scheme, hedges 80% of the currency exposure.
  • Strong past performance, as it has consistently remained in the top three in the past three, five and seven years.

Watch the full show here:

Here are the edited excerpts from the interview:

Chintan, tell us about this, what is this concept of the Low Vol 30 ETF Fund of Fund?

CHINTAN HARIA: The name is long but the concept is very simple. It is a fund of fund offering on one of our ETFs. So, if we see what has happened in the last three-three and-a-half years, we’ve seen a growing trend among investors for getting invested in Smart Beta, ETF strategies—so passive funds which are essentially ETFs and index funds are growing in popularity and with new passive funds, we have seen a growing trend of high net worth Individuals moving towards Smart Beta strategies and within the Smart Beta strategy, what is a smart beta? The selection of stocks is based on a particular factor, we felt that smart beta strategies around low volatility area good fit for the long term wealth creation journey of any investor.

So that’s where about three and a half years back we launched the Nifty Low Vol 30 ETF. As you all know ETF can be invested by those who have a demat account and a trading account but a large section of Indians do not invest necessarily through the demat and trading account and don’t want to invest in a smart beta strategy. So, for those investors we’re bringing out the Nifty Low Vol 30 ETF Fund of Fund, which is essentially a wrapper or a product which invests ultimately in the ETF itself. So, for a simple investor to invest in a systematic investment plan or a lump sum method without having a demat or a trading account, the fund or fund is a route which they can take and the NFO is opening on March 23 and closing on April 6. The concept of low volatility of course as we move along, we’ll come to, but this is simply bringing in simplicity for those who are wanting to invest in Smart Beta strategies in the passive side, so the fund of fund route, while keeping the taxation same as equity taxation.

So essentially this wrapper, as you call it will mirror the returns of the underlying ETF, am I correct?

CHINTAN HARIA: So the idea is that the FOF is investing in the ETF so whatever returns the ETF gets that similar return you should get in the fund of fund as well. There are minor tracking errors which will come in but as an overall basket, ultimately the entity is going to track the underlying index through the ETF route.

Why should somebody believe that this underlying index that you’re speaking about has merit to investing in it?

CHINTAN HARIA: It’s the underlying index which is important, if you invest through the ETF route or the fund of fund route is up to your choice. It’s basically bringing in the convenience of whichever platform you want to invest in. The whole idea or the concept of low vol itself is very appealing for two reasons. One is in life in general we like stability and in every aspect of life similarly, if in stocks as well or in equities if we can choose 30 stable stocks which is 30 stocks gives us good diversification and the 30 stocks on low volatility are chosen out of a universe of the top 100 stocks. The product is very simple. The index provider which is the NSE indices has a methodology that we’re based on. The top 100 stocks are the universe and out of the top 100 stocks, 30 stocks are chosen on the basis of lowest volatility of the last one year are a part of the index and as an investor, you will get a representation of those 30 stocks and the stock selection, as well as the weights are on the basis of low volatility. So, the stock which is lowest on volatility, gets the highest weight. So, not just the selection but also the weight is on the basis of low volatility.

Now the whole concept of low volatility itself, just to elaborate is a very simple concept. We all know that risk adjusted returns is something which international investors look upon a lot and even in India it is catching up ground among investors and we are seeing a large set of Indian investors looking at low vol 30 ETF because on a risk adjusted returns parameter, it does provide a better return. Low vol means stocks which are more stable. In the past 15 years of my working career in the mutual fund industry I’ve seen enough people because of the volatility in the market come in at the wrong time and who are going out at the wrong time and March 2020 was a classic example but because the volatility increased people ran away and it is trying to avoid that greed and fear. If you have a set of stocks which are more stable hopefully the investors remain invested for the long run and participate in the long-term wealth creation journey of equity. The risks of equities remain in any equity product and it will also remain in this product but at least the stock selection is on the basis of those stocks which are lower on volatility, which are more stable and hopefully the investors can participate in it for the longer run.

One, how well against benchmarks has this product been able to do across time periods; did you back-test it then, so to say since 2017, Chintan? Any remarks there?

CHINTAN HARIA: The nifty low vol 30 index data which is being tracked by the ETF is pretty much available since 2005 and if we look at the data since 2008 which we saw, even in years which have seen significant out-performance of the market itself like 2009 or 2014 or 2017, this product has been able to deliver equivalent or better returns than the market while the volatility is lesser. The past returns may or may not recur in the future but the concept of low volatility in the long run, a five-year or a 10-year period has been able to deliver a better experience then the relevant broad market indices.

That’s what the index data is suggesting and in the last three, three and a half years if you look at it from the ETF perspective since it’s been in existence, the very fact that it has been able to generate stable and positive returns for the investors in the three to three-and-a-half-year period, at a time when the market itself has been very narrow, most investors have been pretty happy with the way it has been able to perform in the last three years as well. Just as a data point in the last 13 years up to 2020, in eight out of the 13 years the benchmark was beaten by this particular index and the balance or the difference here was not much in terms of the performance. I think from a strike rate perspective, this index has done well and as you would know that no particular factor can work in all market conditions. Like in the last six months, if it’s a high beta strategy which has worked better because there has been a significant change in the market direction, then you will find that this product may underperform a high beta strategy when the high beta does well but that’s not the point. The point is an investor’s allocation into a particular product will be the basis and overall asset allocation which the investor will come to. We firmly believe that low vol as a strategy for the long run does fit an investor’s portfolio much like the dynamic asset allocation funds fit an investor’s portfolio for the long run.

Tell me, this product could be terrific for somebody who is seeking a lot more stability but for somebody who is a lot more adventurous and willing to take higher risks, would this product pair in comparison to maybe some of the others? I’m just trying to understand that maybe it’s fantastic for people who want stability. Could there be other products which can be more suited for somebody who doesn’t mind that higher element of risk as long as she or he’s wanting to chase higher returns?

CHINTAN HARIA: Essentially if we see in the last one-year, three-year, five-year or seven-year data, if you look at it, choosing a particular index out of the many options that any investor has is always a tricky part and you can always say in hindsight that a particular index did well in one year and you could have invested in that but at a portfolio approach, if I see three years, five years, seven years or 10 years, this index has been able to deliver a better return as compared to the other broad market indices especially if we adjust it for risk. When you mention adventurous investors, of course, adventurous investors one year back when we had a view that commodities is going to do well and we launched the commodities fund on the active side, no doubt, the commodities fund has given a much better return compared to the low vol 30. So, if the investor does have the ability to pick the right high beta index or the strategy at the right time, yes the investor can choose that, but I think very few investors have that ability, and that’s why as a longer-term stable allocation this fits in well. Overall, from 100 rupees if I say 10 to 15 rupees in this particular strategy won’t hurt the investor because I know that most investors wouldn’t want to have more than 20-30% in high beta strategies. So, I’m saying the rest 70% can be well established between this and dynamic asset allocation.

So, it sounds fairly good, the performance has been strong, everything looks okay, what are the risks to this?

CHINTAN HARIA: One of the risks which you mentioned of course is there will be times and shorter time periods where the market may change direction in favour of high beta stocks and those high beta stocks may outperform which may bring a marginal underperformance of this particular portfolio versus the broad market indices. But in the long run, like I said, if we stay invested, I think this has a place as an asset allocation for all investors in the fully invested equity category and that’s where the ETF itself of ours, which was a sub-10 crore category for us about three years back is now a 250-crore plus category. So, we are seeing interest among HNIs and that’s where we are bringing the fund of fund to take it to the larger set of audience who are looking to invest in fully invested equity funds. Apart from this, of course the necessary risk of equity lies. So, if the entire market itself falls, then, this being equity will fall too. So, this should suit an equity allocation, let me reiterate, it’s an equity allocation product. It does not take cash calls, it’s not going to reduce its equity when the market goes up. So, if your overall asset allocation allows you to invest in equity, this should be a good product and a good fit on the long-term wealth creation perspective.

Let’s talk about this NFO.

KIRTAN SHAH: This isn’t an NFO in that sense, in my opinion is because there is already a fund which is existing in the market on which this fund of fund is coming ahead. This should not be looked at as a common or a denominated NFO like any other NFO which is coming out in the market. Now, predominantly while we are trying to look at the ICICI Nifty Low Volatility 30 ETF, the index has been in existence for four years, the ETF has been in existence for three and a half years but the index because it’s a smart play, it has been reconstituted back to 2005. Now if somebody like me has to look at this product, of course, like Chintan also said this is meant to make sure that investors who are looking at low volatility are the ones who come in this product.

So if you have to look at this particular product I will look at it in three brackets. The first, has the index in itself on which the ETF or the FOF is going to be based, performed well since 2005 or not and because this is a low volatility product has it been able to protect the downside, which to a greater extent is the appeal for which people are going for, in this product. Very importantly because it’s an ETF, how does the tracking error of the fund perform? So, if you look at all of the three data, I think this is a good fund. So, let me give you some stats and data points. While we looked at the constituted index from 2005, we saw a couple of areas where the Nifty fell so let’s say when the Nifty fell, in the calendar year 2008 by 53.1%, this particular product fell only 42.3% on an index level. Similarly, in 2011 when the Nifty 24.9%, this product fell only 12% and in 2015 when Nifty fell 1.3% in the calendar year, this product outperformed with a positive 9.8% return. So, does the index really protect downside? The answer is yes. Now another answer to look at is, can the index also outperform in good times? If we look at calendar year 2009, when Nifty 100 gave 84.9% return this product gave 92.9%. Similarly, there are multiple instances that I can share where this product has also done well when the markets are also going up. So, does it protect the downside and also perform well when the markets are going up? The answer is yes, point number one. Point number two, I think if you look at it from a tracking error point of view, this product has given a tracking error, anywhere in the range of 0.3-0.6%, because this is quarterly rebalancing and there is some buying and selling that will keep happening. From that perspective, if this is going to be quarterly rebalanced, I think a 0.3% or a 0.6% of tracking error is good. So overall, looking at the last 16 years, the returns on this particular product has been 8.4% CAGR versus Nifty 100 of 14.8%. That has come along with lower volatility, so the standard deviation of this product is 18 versus 22 on Nifty 100 and it also protects the max drawdown from a financial year point of view. This index that we are talking about has the maximum drawdown of over 49%whereas for Nifty 100 has a drawdown of 61%. So, looking at all of these three things, I think the index is really meant for somebody who wants to take low volatility and I don’t see a reason why this should not be a fit for somebody who’s looking at low volatile investment in their portfolio.

Let me ask you a counter question. Everything seems to be okay with this, right? You’re saying that it has under-performed in years of downturn, it has outperformed in periods of upsides as well. So, if everything is right for what kind of investors is this product not suitable?

KIRTAN SHAH: Answering that question very straightforwardly, look, a lot of people who have a higher risk appetite are basically looking at a very significant alpha over the index, may not really be happy with this product as such. That is because there are multiple instances where the product has really underperformed the market. So, if you look at 2007, where the bulls were really riding, the Nifty 100 gave 59.5% return but this index gave only 31.5% return and it underperformed 28% in terms of alpha. The point that I’m trying to make is that probably when momentum stocks are supposed to move in a bull market and in a liquidity driven market this definitely as a product will underperform or I would rather say this is expected to underperform. So, this is not meant for people in my opinion who are looking at significant alpha over the index but having said that over a period of time, I think given the last 16years of data that we look at, this fund is still very comfortably with a lower volatility also able to outperform the index very well. I think for very adventurous investors, this may not fit but this can be a good fit for almost all the investors in my opinion.

In the current juncture in the scheme of things that exist, what is a product that you believe investors should opt for? Are you very keen on recommending a flexi-cap offering, are you looking at a mid-cap or a small-cap offering? Why that category and then which fund within that category?

KIRTAN SHAH: I think for a lot of us as retail investors who probably would not have a lot of understanding and cannot do the cherry picking of which market capitalisation will work in which business economic cycle, I think flexi-cap in my opinion fits right in that sense, where you leave it to the fund manager to make the calls on their own and let the fund manager decide how much allocation should be given to large-caps or small-caps and mid-caps. So, for somebody who’s not really into fund management, understanding the economic cycles and which market cap will really work should definitely go ahead and set it for a flexi-cap fund. In my opinion if you really ask my pick, I think Parag Parikh Flexi-Cap fund is a fund that we’ve been recommending to clients over the last half a decade. I think this fund really has done well in the past and we feel that it will continue to do well. On multiple aspects, we think that Parag Parikh Flexi-Cap fund will end up doing well. So, let me touch base on the softer aspects first. I think there are two softer aspects that I would like to highlight. First, this entire AMC has only one equity scheme that it’s really been focusing on and putting all the hard sweat and energy into it. They’ve just come out with an ELSS fund but over there also if you look at the portfolio except for international exposure, the portfolio is almost the same. So, I think the entire AMC is focused and concentrated only on one product which is a good sign in our opinion. Also, if you look at it from the other perspective, I think the fund itself has skin in the game. If you look at the key managerial people in the fund, they are close to 188 odd of crore rupee worth. People have their own money invested in the fund, in fact their CIO has close to Rs 20-odd crore invested in the same fund. I think for the softer aspect, the key managerial people have skin in the game. Their concentration is completely on this particular product and I think on the softer aspect that is something that we like. Now, because we feel that the markets are probably richly valued at this point in time, you have FY23 earnings that you have factored in too. I think risk management plays a very important role in our opinion while we end up selecting funds right now. The most important thing that we really want to understand and work on, is diversification. Now this point, not only brings up local diversification but it also brings global diversification. So, this particular fund typically is investing 65% of its money in domestic equity and roughly close to 35% in international equity. Currently that we speak from the latest factsheet that we have close to 29% of the investments are globally diversified, specifically in the U.S. tech stocks. Now what that does is, it brings in diversification and reduces the co-relationship. Of you look at some co-relation data, let’s say a Nifty 500 Total Return Index and if you look at the NASDAQ, they are only co-related by 0.18%. I think that really to a greater sense reduces risk in the portfolio because the diversification is not just local but global. Of course, the most important point to be discussed here is that if you are doing global diversification, is the fund taking currency risk?

As far as we understand and the detailed understanding that we have about the product, close to 80-90% of the portfolio is generally currency hedged. So, they work in the futures market and hence the currency but because the Indian currency typically depreciates to the U.S. dollar, there is always that slight advantage that the fund has with the rupee depreciation. If you look at it from that sense, the rupee depreciation of the unhedged currency exposure typically takes care of some portion of the TER (total expense ratio) of the fund. The TER of the fund ideally and is slightly lower in the real sense is because some part of the TER is through the currency depreciation. Having said that, most part of the currency risk is typically hedged and that’s how it takes on. One last point that I would really want to make here is, looking at the past performance, if you look at this point since its inception on a three-year rolling basis, there has been not one single period where the fund has given negative returns. The minimum return that the fund is given is 0.07% versus the flexi-cap category which has a -8% kind of a return. If you look at it from a risk adjusted basis this point has given a 6.5% alpha versus point 0.15% alpha on the flexi-cap category generally and the drawdown of this fund is only 41 versus the category average of 95. So, I think this is in our opinion a brilliant product to be invested in right now—not just looking at the past performance but also looking at the current exposure of the fund as well.

Any risks to this fund, at all? I mean, does it have any chinks in the armour?

KIRTAN SHAH: Well, the larger performance of this fund has been driven by the international exposure. So, if the dollar moves inversely, the 0.15% unhedged might probably not work in our favour and probably because this has a larger NASDAQ exposure to global equity, I think the technology space sector exposure of this fund is slightly higher. If that does not work, probably this fund might underperform.

One final question and that is on this very interesting data around this belief that funds with a higher corpus typically tend to underperform. It’s a belief that has seeped into a number of people’s minds that okay let’s not look at a fund which has got thousands of crores of AUM because the size will hamper its ability to perform. Any thoughts, any research that you have out here and any anecdotal evidence which suggests to the contrary or affirms the same?

KIRTAN SHAH: Identifying this has become very difficult and I’ll tell you why. Over the last three years, SEBI has changed categorisation rules because of which the schemes have changed and the stocks in which that they’ve invested, aggressively. Also, what has happened is, while we were looking at this particular data, there is not a lot of data available around the rolling return because of the change in the SEBI categorisation pool but having said that there is some data that I can present to you. What we did was, we looked at the top three or the highest AUM funds and we looked at the three funds which have generated the highest returns and we looked at that in the large-cap, multi-cap, mid-cap and the small-cap space. Now what we realised is, while we looked at the large-cap and the multi-cap space, we understood that the AUM had very little or no co-relation to the funds’ performance. So, we looked at the one-year and the three-year data and we found out that the funds which were generating the highest return versus the funds which had the highest AUM, there was no real and direct co-relation.

Now, that is what led us to believe a little in the hindsight that probably, the funds which have the freedom to invest in large-caps probably might not have this problem of the AUM increasing it because managing the same becomes a little difficult. But when we did the same study on the mid-cap and the small-cap space, we definitely understood that there was some element where the AUM was playing a role. So, we digged the same data and then we looked at the top three, AUM funds and we looked at the top three return generating funds in the mid-cap and in the small-cap space. We then realised that definitely, the AUM has a role to play here because there was a significant difference in the performance of schemes which performed well over the last three years versus the schemes which had a higher AUM. The schemes which had a lower AUM, had significant alpha over schemes that had a higher AUM. But having said this, one disclaimer because schemes have changed the categorisation and hence the rolling return data was slightly difficult, this may look slightly premature but whatever little evidence on the research that we have shows that the large-cap, multi-cap may not have a problem with increase in the AUM but mid-cap and small-cap should have some problem in managing those assets because of the liquidity available. Hence that should be one component that you take into consideration when you look at the mid-cap and small-cap funds.

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