There is a way out through which you can get relatively better returns while minimising the amount of risk associated with volatility.
Equities are inherently volatile due to which many people avoid investing in them. But then investing in equity is the only way through which you can beat the inflation and create wealth in the long run. How much volatile the equity market can be has been witnessed by all of us very recently during the crash of March 2020 due to the Covid-19-induced fear and the quickest recovery of it thereafter.
A fixed deposit gives you risk-free returns whereas equity investing can give you higher returns, but with very high volatility associated with it. There is a way out through which you can get relatively better returns while minimising the amount of risk associated with volatility. Let us discuss.
What is volatility and what is its role in investing?
Volatility is the movement in the price of equity shares in reactions to news around us. So, the prices of shares and indices move in both the directions on a daily basis. Volatility and returns go in hand. The higher the volatility, the more are the chances of you getting higher returns. The risk capacity and aptitude differs from person to person due to various reasons like age, consistency of income and importance of the goal for which one is saving.
However, unless one is willing to take risks, one cannot reap the benefit of higher returns. This was proved during the recent correction due to the Covid-19 outbreak. Those who took the risk of investing in the correction are sitting on handsome profits now. However, one should try to avoid volatility as far as possible while taking investment decisions, else it takes the form of gambling.
Relationship of active investing and passive investing with the returns on investment
Investing in index funds is called passive investing as the fund manager does not have to do any research and has to just replicate the index and thus comes at lower fund management expenses, but it generates returns just around the index fund. However, if one invests in active funds, there is the probability of earning higher returns than the broader market returns. The higher returns come at cost of higher fund management charges. The deviation in returns of the active fund from its benchmark may by both the ways. The difference in returns over the benchmark is called Alpha. Though an Alpha may be positive or negative, but we generally associate the word Alpha with extra positive returns.
Is there any possibility of one earning higher returns (Alpha) while having lower volatility?
The NSE had launched an Index of 30 shares from a universe of 150 shares comprising of Nifty 100 Index and Nifty 50 Midcap Index called “Nifty Alpha Low-Volatility 30 Index”. This Index was created by selecting 30 shares which had generated an Alpha while having low volatility in the returns generated over the years out of 150 shares comprised in the above indices. For the 18th August 2021 ended 10-year period this index has generated an annualised return of 20.20% against the Nifty 50 return of 14.20%. These higher returns have come on the back of lower volatility measured on the basis of annual standard deviation of its return which are 14.46% and 16.46% for the Nifty Alpha Low volatility 30 index and Nifty 50 index, respectively. So, this index combines best of both the worlds.
Since investors cannot trade in indices during the market period, the mutual fund houses launch ETFs (Exchange Traded Funds) for the investors to effectively trade in indices. ICICI Prudential Fund, for instance, had launched an ETF replicating this index during the month of August 2020, called “ICICI Prudential Alpha Low Vol 30 ETF”. For dealing in ETFs which are traded on stock exchanges, you need to have a demat account and a trading account which is a hurdle for many investors. So, to help such investors who do not have a demat account as well as those who wish to invest and reap the benefit of rupee cost averaging through systematic investing through SIP and STP, ICICI Mutual Fund has come out with a fund of fund called “ICICI Prudential Alpha Low Vol 30 ETF FOF” which will invest in the above ETF.
Taxation of Fund of Funds investing in ETF
Since this FoF will invest a minimum of 90% of its corpus in its own ETF which in turn will invest a minimum of 90% of its corpus in shares of listed companies in India, it will be treated as an equity-oriented scheme and thus will be eligible for concessional tax treatment. Any profit made on equity-oriented schemes for a holding period of 12 months and less is taxed at a flat rate of 15% whereas the profits made on holding for more than 12 months is tax-free up to Rs 1 lakh (along with long-term capital gains on listed shares) and then is taxed at a flat rate of 10% without indexation.
(The author is a tax and investment expert, and can be reached at email@example.com)
Disclaimer: These are the author’s personal views. Readers are advised to consult their financial planner before making any investment.