There is a low volatility ETF and an FoF (which invests in the ETF)
And now there’s a UTI Momentum Index Fund.
I see both indices as positive.
One investor asked: which is better? Low Volatility ETF or Momentum Index Fund? Should we invest in both? Easy question. Difficult answer.
This post is likely to disappoint you if you are looking for an objective answer. The decision will ultimately boil down to your conviction. I just want to highlight a few aspects of stock selection in these portfolios and that these portfolios (although based on such opposing strategies) may have a lot in common.
The calendar year returns
I only compared the calendar year performance of the low volatility and momentum indices to the Nifty 50. A detailed comparison between different factors between rolling returns / risks and drawdowns can be found in this post.
Since April 1, 2005 (until March 31, 2021) the Momentum Index has shown a CAGR of 19.9% pa. The Nifty Low Volatility 30 index achieved a return of 18.4% pa. Nifty 50 yielded 14.5% pa
You can see that the performance of both factor indices is very impressive. And purely from a return perspective, there is little choice between the two indices.
You would expect the Low Volatility Index to be less volatile than the Momentum Index. Finally, the momentum strategy picks stocks that go to a specific location. Let’s look at the rolling risk graph from one of the previous posts.
While the Low Volatility Index is less volatile, the Momentum Index won’t take you on a breathtaking ride either. It is much less volatile than value and alpha factor indices. During some stretches, it’s even better than Nifty 50 in terms of volatility.
Why is this happening?
Because the momentum index method has a volatility filter.
How are stocks selected in these factor indices?
The low volatility index includes the least volatile stocks. Law.
And the Momentum Index tracks stocks that have performed best in the recent past. Not quite right.
Momentum isn’t just about picking the best performing stocks (including stocks that have risen the most over a period of time). The path a stock takes as it moves up is also important.
If all else is equal, the stock with a gentler rise will get a higher momentum score than the stock with a very volatile rise.
Suppose there are two stocks, A and B.
Camp A goes from Rs 50 to Rs 100. The path is: 50, 55, 60, 70, 65, 75, 85, 95, 100. (Smooth climb)
Stock B also goes from Rs 50 to Rs 100. The path is 50, 70, 85, 65, 55, 95, 70, 100. (Volatile rise)
We can see that Stock A is much less volatile than Stock B and has seen a much gentler increase from Rs 50 to Rs 100.
Therefore, stock A has a better momentum score than stock B.
In this document you can refer to the stock selection method for various factor indices.
And because the momentum index method takes into account the volatility of stocks, you can expect portfolio overlap.
The portfolio overlaps
A stock cannot rank well on just one of the factors. A stock can rank well in many factors and be part of multiple indices.
For example, there is an overlap of 11 stocks between the Nifty 200 Momentum 30 Index and Nifty 100 Low volatility 30 Index.
Between Nifty 200 Momentum 30 Index and Nifty Low volatility 50 Index there is an overlap of 16 stocks.
Of course, we need to look at the stock weights as well, but I’ll skip that comparison in this post.
By the way, a common perception is that the momentum index will only contain junk stocks. That’s not true either. I checked the overlap between the Nifty 200 Momentum 30 index and the Nifty 200 Quality 30 index. There were 11 shares of common stock. Another perspective: Even quality stocks can get going.
9 stocks in all three indices (Momentum 30, Low Volatility 50 and Quality 30).
This overlap shows that even by investing in a single factor (momentum, low volatility) you are also exposed to other factors.
What to choose between the Low Volatility ETF / FoF and the Momentum Index Fund?
I don’t have a straight answer. It depends on your conviction.
These factor indices (or any other strategy) will underperform. If you don’t believe it, you will likely get off because of frustration. So when you have to choose between low volatility and momentum, choose the strategy that you are more confident about and that you can stick with.
OR don’t pick any and just stick with market cap based indices.
OR choose both if you are convinced of both strategies.
When you need to invest, consider factor indices as part of your satellite portfolio. This can be a substitute for actively managed equity funds in your portfolio. Start small. As you develop comfort, you can increase exposure.
Points to note
- Please understand that this is NOT a recommendation to invest in any of these indices. There is no guarantee that the low volatility or momentum indices will continue to outperform market cap based indices such as Nifty and Sensex.
- Much of the data for these factor indices is back tested. The Nifty Low Volatility 30 index was launched in July 2016 and the Nifty Momentum 30 index in August 2020. The Low Volatility Index clearly has a much longer live data history than the Momentum Index. You can be sure that of all the methods used to calculate the low volatility or momentum score, the best performing method has been selected.
- I used TRI data. The ETFs or the index funds have costs and tracking errors. The cost and tracking error may be higher for factor indices (compared to market capitalization based indices).
- When serious money is chasing a particular strategy, you can expect the alpha to deviate from those strategies.