The 4th 2023 quarterly rebalance of the CM Low Vol portfolio went out to Capitalmind Premium and CM Low Vol smallcase subscribers earlier this week. This post covers a quarterly update of our factor portfolios: CM Low Vol and CM Momentum. We look at an example of how factors can be surprisingly effective. And we also use chatgpt for some quick analysis on whether recent volatility has been higher than in the past and the relationship between volatility and the likelihood of market declines.
A short introduction to the two portfolios for new readers:
Capitalmind Momentum
CM Momentum is a long-term quantitative strategy that invests in stocks showing strong price and volume momentum. The underlying principle of Momentum investing, is consistently buying stocks showing stronger relative price momentum offers a strong probability of outperforming the market when implemented over three+ year timeframes. The momentum effect has been well-documented in academic and practitioner research globally.
Our portfolio is sector and market cap agnostic, holds up to 25 stocks selected from all NSE-listed stocks meeting minimum criteria in daily traded volume and market capitalization. The portfolio is reviewed weekly and rebalanced based on a set of price and volume parameters. The portfolio aims to capture the best performers in the market and let the winners run with a disciplined approach. When stocks meeting entry criteria are not found, the portfolio allocates to alternate assets like Gold, Debt or Cash.
Capitalmind Low Vol
CM Low Vol is a long-term quantitative strategy that invests in stocks that have lower volatility than the market. It is based on the principle that stocks with lower past volatility than the market, can deliver higher returns with lower risk over the long term. The Low Volatility effect has been also been documented in various research papers, like ‘The Volatility Effect revisited‘
Our portfolio is sector and market cap agnostic, holds 15 to 20 stocks selected from all NSE-listed stocks meeting minimum criteria in daily traded volume and market capitalization. Historically, the low volatility portfolio holds more large and midcaps due to the selection criteria or relative volatility. The portfolio is rebalanced quarterly based on a set of volatility and diversification parameters.
Recent Performance
Table shows the recent performance of the two portfolios over the last 1M to 12M windows.
Chart shows year-to-date performance in 2023
After running up from April to August, markets took a breather till October before resuming the uptrend. The Nifty is up 10% in 2023. CM Premium Low Vol is up 16% and CM Premium Momentum is up 34% in the year so far.
Capitalmind Low Vol since inception
The Low Vol portfolio has now completed two years and three months since it went live. It recovered after a rocky start and has done 11.2% annualised compared to 9.2% for the Nifty over the same time frame.
Capitalmind Momentum since inception
CM Momentum has been live for nearly five years and counting. The chart shows the cumulative performance of ₹100 invested in the CM Momentum portfolio at inception in Jan 2019.
Since the last update in August, the Momentum portfolio has made new highs even as markets have been more volatile over the last few months.
One-year rolling returns
Chart shows one-year rolling return for CM Momentum and CM Low Vol. The purple line only starts in August 2022 since that’s when Low Vol completed one year after going live.
A rolling return chart shows how often or not an active strategy has been ahead of the index in its history.
The chart below is one of our high-level gauges of strength in equities. It shows the median one-year trailing returns of the universe of over 1,500 stocks, not just the handful that decide the direction of the index. The shaded band represents the range between the 10th and 90th percentile of one-year returns.
Has volatility been going up
After a smooth ride from April to August, markets have been “feeling” more volatile. I recruited chatgpt to analyse for me to see if volatility since August this year has been higher than usual. I uploaded historical TRI data for the NSE 500.
Turns out it’s been the opposite. Volatility has been trending down over the last three months compared to the 12 months before that.
The next logical question was, are periods of low volatility followed by near-term corrections? Two prompts later, chatgpt produced this.
Low Volatility periods are periods where the annualised rolling 252-day volatility was in the bottom 25 percentile. Market Declines, in this case were defined as declines of 5% or more over 30 days.
- Annualized Volatility and Low Volatility Periods:
- The first chart shows the annualized volatility over time. The red dashed line represents the threshold for low volatility, set at the 25th percentile of the volatility distribution.
- The grey-shaded areas highlight periods of low volatility where the annualized volatility was below this threshold.
- Total Returns Index and Market Declines:
- The second chart illustrates the Total Returns Index over the same time period.
- The red shaded areas indicate periods identified as ‘market declines’, defined here as a decrease of more than 5% in the index value over a 30-day rolling window.
- Probability Analysis:
- The probability of a market decline after a period of low volatility was calculated to be approximately 8.92%
- For comparison, the overall probability of a market decline in the dataset was higher, at around 18.34%
Turns out historically periods of high volatility are more likely to be followed by short-term declines than low volatility.
Quick exploratory data analysis is now several times faster with LLM tools, which are now widely accessible. I’d written about this in more detail when I first started exploring the use cases of using AI for basic investment analysis.
An example of how factors can be surprisingly effective
We started the CM Low Vol portfolio in September 2021. We started work on it early that year, driven in part by the exuberance for anything momentum at the time. While many of our peers were busy launching flavours of momentum-style portfolios with lots of takers, the question we posed ourselves was: What is the least momentum-like factor we can explore that offers a counterbalance to buying stocks that have been going up? The logical candidates were Value and Low Volatility. After delving into the literature and analysing how their basic forms have historically done in India, we arrived at our version of Low Volatility.
The core concept of Low Volatility investing is deceptively simple: buying a portfolio of stocks exhibiting lower relative volatility than the universe and rebalancing at a reasonable frequency will deliver decent excess returns. The fact that backtests show a skew towards quality large-caps as the primary constituents make it even more suitable as an addition to a primarily Momentum portfolio.
In September 2021, one of the constituents that scored high on the Low Vol algorithm was the CPSE ETF.
A quick primer: CPSE ETF stands for Central Public Sector Enterprises Exchange Traded Fund. It is an exchange-traded fund (ETF) that invests in the stocks of Central Public Sector Enterprises (CPSEs) – companies where the Government of India holds majority stake. The CPSE ETF tracks the Nifty CPSE index, which consists of select Navaratna, Maharatna and Miniratna public sector companies. Currently, the ETF invests in 11 stocks from the energy, power, infrastructure, and defense sectors including ONGC, NTPC, Coal India, BEL etc.
Chart below shows what the CPSE ETF had done with respect to the Nifty up until that point.
From April 2014 to Aug 2021, ₹100 invested in the CPSE ETF would be worth ₹155, miles behind the ₹263 that an investment in the Nifty would’ve been worth.
You didn’t need Berkshire Hathaway-level analysis skills to figure out why. Here’s a concentrated mix of companies operating in largely commodity industries known for their legendary levels of bureaucracy. Add to that the majority promoter’s tendency to treat them as its personal piggy bank.
But with quantitative investing, everything boils down to one rule: Trust the process.
So CPSE ETF became part of starting Low Vol Portfolio. It continues to be in the portfolio as of the latest rebalance. The chart below shows what CPSE ETF has done from then until now.
Since Sep 2021, ₹100 invested in the Nifty would be worth ₹115, and ₹220 if invested in the CPSE ETF.
As PSU stocks have done better than most other stocks over the last two years and more, there has been no dearth of expert commentary on why they were poised to do well.
Just a couple of examples below
What’s driving investors to PSU stocks? – Fortune India (Oct 2021)
A decadal shift is happening in PSU stocks – Business Today (Sep 2023)
Imagine if the portfolio wasn’t called Low Vol but something like ‘Deep Value’ / ‘Unrecognised diamonds’. We’d be able to attribute deep analysis into the megatrends that enabled us to foresee that investor interest in these companies was about to rise dramatically. Instead, it made it into the portfolio because of a quantitative relative price volatility factor combined with shorter-term price trend filters.
Now, that might not be as intellectually satisfying as seeing the rise after having offered up a 120-slide deck on why PSU company stocks were poised for greatness. However, quantitative factor-based investing offers an under-appreciated advantage. The near complete absence of ego in the process. This means when things change with either the underlying businesses or the sentiment about them, causing the stock to fail the rules of the portfolio, it exits at the next rebalance without the cognitive dissonance that comes from having taken a strong and public position about a stock.
That ability to not personally identify with your holdings might be the biggest behavioural advantage that quantitative investing offers over traditional forms.
Previous Updates:
Momentum makes a comeback, Low Vol continues steadily – Aug ’23
The ebb and flow of momentum and low vol – May ’23
Other CM Portfolios:
CM Equity Mutual Fund Portfolio completes 1 year
Looking for the best PMS for your investments? Check out Capitalmind PMS, the investment strategies and updated performance.
CM Premium subscribers, please ping us your queries on #helpdesk. Or DM us on twitter @capitalmind_in
This post is for information and not a recommendation to buy or sell any stock. Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
