MINIMUM VARIANCE IS an investment approach that focuses on reducing fluctuations within a portfolio. To explain its relevance, let us imagine that a person is attempting to cross a river with an average depth of five feet. If certain areas of the river are deeper, relying on the average depth can be misleading and even dangerous. Similarly, in investments, an average return may mask the underlying fluctuations that can impact the overall experience and outcome for investors.
Variance is a measure that captures how much individual data points deviate from the average. In a dataset, a higher variance suggests that numbers are spread over a larger range, indicating more volatility. To illustrate, consider a person travelling to the airport with an estimated travel time of one hour. During peak traffic, the time might increase to 1.5 hours, while during off-times, it may decrease to 45 minutes.
These fluctuations form the average indicate variance. In investing, a portfolio with high variance will experience more dramatic swings in returns, while a portfolio with low variance, but similar average return, will tend to give a relatively smoother experience.
In recent years, variance has become particularly relevant due to shifts in market behaviour. Portfolio allocations have gradually changed, moving away from balanced mixes of equity, debt and hybrid investments. With increasing returns and a higher risk appetite among investors, more portfolios now lean toward equities, especially in the midcap and small-cap segments, which tend to be more volatile. Past performance of these segments has further attracted investors. This shift underscores the importance of managing variance within portfolios.
Also, the valuation of the stock market has climbed well above its historical average, creating conditions where volatility is likely to remain high. Meanwhile, corporate earnings growth has moderated. This has added unpredictability to stock performance.
Geopolitical tensions also contribute to market fluctuations. However, India’s growth story remains a source of optimism. A strong government balance sheet, stable banks, healthy corporate balance sheets, and robust household finances contribute to India’s resilience in the face of challenges. Yet, while this long-term potential is promising, short-term fluctuations are unavoidable, which makes controlling variance even more appealing.
Another significant factor influencing the market is the pattern of foreign investments. Recently, foreign portfolio investors (FPIs) have reduced their exposure to Indian equities, particularly in large-cap stocks. A reversal of this trend in the future could potentially lead to improved performance in large-cap stocks, adding to the case for managing variance to navigate through such periods effectively.
A minimum variance approach to investing focuses on creating a stable return experience by prioritising risk-adjusted returns rather than seeking the highest returns. This approach may not always deliver the maximum gains, but it aims to control the swings in value, which can provide peace of mind to those cautious about market volatility.
Active portfolio management can further help by factoring in broader economic elements, such as interest rates, commodity prices, and global growth trends, which contribute to a portfolio’s overall stability. A focus on low variance helps in reducing potential losses during volatile periods, and careful stock selection adds a layer of risk management, making this approach suitable for long-term investors who prioritise stability.
As markets remain volatile due to various factors, such as increased risk appetite, high valuations, and global uncertainties, low variance strategies can offer protection from sharp market swings. For investors who seek exposure to equity but prefer a more stable experience, this approach provides a reliable means to pursue growth while managing risk. Embracing this approach reflects the belief that, while market fluctuations are inevitable, a steadier investment journey can deliver both peace of mind and consistent returns over time.
In line with this, investors may consider ICICI Prudential Mutual Fund’s new offering―ICICI Prudential Equity Minimum Variance Fund―open from November 18 to December 2, 2024. This scheme suits investors seeking long-term capital growth and equity exposure with reduced market volatility, focusing on large-cap companies with good corporate governance and high cash-flows.
The author is founder, Perpetual Investments.