Your Questions Answered: Should I invest in BSE Low Volatility Index tracking mutual funds?

Q. My wife and I have been investing in ELSS mutual funds for the past 5 years. However, we have been concerned with the volatility associated with our current portfolio, especially during the past 1 year. Our friends have suggested that we explore passive mutual funds, specifically funds tracking the BSE Low Volatility Index. Kindly, elaborate on the pros and cons of investing in the BSE Low Volatility Index.

Omveer Shukla, Pune, Maharashtra

What is the BSE Low Volatility Index?

Investing in the stock market can be thrilling, but it often comes with significant risks due to market fluctuations. For investors seeking stability, the BSE Low Volatility Index offers an attractive option. This index is designed to track stocks that exhibit lower price fluctuations compared to the broader market, making it a preferred choice for risk-averse investors. 

The BSE Low Volatility Index is a benchmark that includes companies with historically lower price volatility. It aims to provide investors with a portfolio that minimises sharp price movements while maintaining steady returns. The index is constructed using stocks from the BSE 500, selecting those with the lowest historical volatility over a specified period.

Eligibility criterion to be part of the BSE Low Volatility Index

The BSE Low Volatility Index is designed to track the performance of companies with historically lower volatility. But how are stocks selected for inclusion in this index? Below, we elaborate on the eligibility criteria that govern its composition.

1. Selection universe: The BSE Low Volatility Index is constructed from the BSE Large-MidCap Index, which consists of large and mid-cap companies listed on the Bombay Stock Exchange. This ensures that the index includes well-established firms with significant market capitalisation.

2. Volatility-based screening: The primary criterion for inclusion in the index is historical price volatility. Stocks are ranked based on their standard deviation of returns, with the 30 least volatile companies selected. This methodology ensures that the index comprises stocks that exhibit stable price movements over time.

3. Weightage methodology: Once the stocks are selected, they are weighted inversely to their volatility. This means that companies with lower volatility receive higher weightage, reinforcing the index’s objective of minimising fluctuations.

4. Rebalancing frequency: To maintain its low-volatility characteristics, the index undergoes semi-annual rebalancing in March and September. This ensures that the stock selection remains aligned with the latest market trends and volatility patterns.

Benefits of investing in funds tracking the BSE Low Volatility Index

Funds tracking the BSE Low Volatility Index focus on companies that have demonstrated historically lower price fluctuations, offering a more stable investment avenue. Below, we delve into the detailed benefits of investing in such mutual funds.

1. Lower volatility and reduced risk comparatively: One of the most compelling advantages of a mutual fund tracking the BSE Low Volatility Index is its inherent risk reduction. Volatility in the financial markets often translates to unpredictability, causing anxiety and potential capital erosion. By focusing on companies with calmer price movements, these funds offer investors a buffer against the wild swings seen in the broader market. This means less stress during turbulent times and a steadier journey toward long-term financial goals.

2. Downside protection: Market downturns can be nerve-wracking, but funds based on low-volatility indices are purpose-built to ease the blow during such periods. Since the index emphasises companies with robust fundamentals and stable performance, these funds tend to exhibit downside protection. In essence, while aggressive funds might soar in buoyant markets and tumble in bearish ones, low-volatility funds cushion the fall by avoiding excessively volatile stocks. This attribute is especially valuable for conservative investors who prioritise capital preservation.

3. Cost efficiency through passive management: Another notable advantage is the typically lower expense ratio of these funds. Because mutual funds tracking the BSE Low Volatility Index follow a passive management strategy, they avoid the higher fees often associated with actively managed portfolios. Lower operational costs mean that a larger share of the returns is passed on to investors. Over time, these savings can significantly enhance net performance, making these funds a cost-effective choice for long-term investors.

4. Enhanced diversification: Diversification is a foundational principle of prudent investing. Funds tracking the low-volatility index achieve this by selecting a diversified array of stocks from various sectors. This enhanced diversification helps reduce the impact of sector-specific downturns on the overall portfolio. By spreading risk across different industries, these funds ensure that adverse movements in any single sector have a muted effect, thereby stabilising overall returns.

5. Risk-adjusted performance: Many investors now focus on not just the raw returns their portfolios generate, but the returns adjusted for the risk taken. Mutual funds based on the BSE Low Volatility Index have often demonstrated superior risk-adjusted performance. Metrics like the Sharpe ratio, which measure return per unit of risk, tend to be more favourable for these funds compared to their more aggressive counterparts. For investors who are particularly sensitive to market fluctuations, this improved risk-adjusted return is an appealing benefit.

Risks associated with investing in funds tracking the BSE Lower Volatility Index

BSE Low Volatility Index aims to reduce the wild swings associated with more aggressive strategies. Mutual funds and ETFs that mirror this index are often touted for their risk-mitigation characteristics. Yet, while the methodology might suggest a cushion during market turbulence, the underlying strategy is not without its pitfalls. We have listed the key risks associated with the funds tracking the index below:

1. Market downturns may not always provide a safety net: Conventional wisdom holds that low-volatility indices act as a buffer during market storms. However, reality can be more complex. For instance, during market downturns, even stocks deemed "low volatility" can suffer significant declines. This anomaly challenges the assumption that a low-volatility strategy universally shields investors during bear markets, indicating that risks remain even in supposedly stable portfolios.

2. Underperformance during bull markets: Another critical risk lies in the opportunity cost incurred during market rallies. In a booming bull market, high-volatility stocks, with their capacity for exponential returns, often lead the charge. By strictly focusing on maintaining low volatility, investors may inadvertently miss out on the gains that come from taking strategic risks. This conservative approach might result in a noticeably muted performance compared to more aggressive indices or diversified growth portfolios, especially when market optimism is high.

3. Sector concentration risk: The composition of the BSE Low Volatility Index tends to favour sectors known for stability, such as FMCG, healthcare, and large financial institutions. While these sectors often provide consistent returns, an overconcentration in any one sector can lead to significant vulnerabilities. For example, if a specific sector faces an unexpected downturn due to regulatory changes, shifting consumer preferences, or global economic factors, the concentrated exposure within the index could amplify losses. This risk highlights the importance of understanding sectoral dynamics and ensuring true diversification in one’s overall investment strategy.

4. Rebalancing and methodology risks: Low-volatility indices generally undergo periodic rebalancing—often on a semi annual basis—to ensure they continue to represent their intended risk profile. However, rebalancing itself carries risks. First, the timing might not always align with sudden market shifts, creating a lag where the index no longer reflects optimum low-volatility characteristics. Additionally, the methodology based purely on historical volatility can be subject to model risk; past performance does not always predict future outcomes reliably. Changes in market behaviour or unexpected economic shocks can render the historical data less predictive, exposing investors to unforeseen risks.

5. Factor-specific risks and overreliance on historical metrics: The low-volatility strategy is fundamentally a single-factor approach. By relying predominantly on historical standard deviations of stock prices, the index may overlook other critical factors such as momentum, quality, or even fundamental changes in a company’s financial health. Economic environments change, and a firm that historically exhibited low volatility might not continue to do so if underlying business conditions deteriorate. Overreliance on a single metric exposes investors to what's known as “factor risk”, where a shift in market regimes could render the chosen factor less effective in reducing risk.

Which companies constitute the BSE Low Volatility Index?

Below is the list of the 30 companies that currently (as on 1 May 2025) make up the BSE Low Volatility Index, along with a brief overview of each:

Who should invest in mutual funds tracking the BSE Lower Volatility Index? 

BSE Lower Volatility Index suits a wide range of investors. We have listed a few categories of investors who may benefit from investing in funds tracking the BSE Lower Volatility Index below: 

1. Risk averse investors: For conservative investors whose primary goal is capital preservation, the BSE Low Volatility Index is designed to mitigate the stress and uncertainty that comes with wild market swings. By focusing on companies that have demonstrated less erratic behaviour, the index provides a smoother ride over time. This makes it a perfect fit for: (a) retirees or those nearing retirement who want to avoid dramatic portfolio fluctuations, (b) income-focused investors who desire regular, predictable returns (c) risk-sensitive individuals who are more concerned about short-term losses than chasing top-end gains.

2. Long-term investors: Investors with a long-term horizon—say, five years or more—can appreciate the cumulative benefits of lower volatility. While such an index might lag during market bull runs (when high-volatility stocks can generate spectacular returns), its consistency over the long term helps build wealth steadily and protects against severe downturns. Long-term investors who are building retirement funds or saving for major life events may find that the BSE Low Volatility Index fits well within their diversified portfolio.

3. Investors seeking a defensive portfolio component: Even for those with a moderate or moderately aggressive risk appetite, the low volatility index can serve as a strategic counterbalance within a broader portfolio. Here’s how: 

(a) Downside protection: In market downturns, stocks with lower volatility tend to fall less sharply. Including these in your portfolio can help preserve capital during adverse market conditions.

(b) Risk-adjusted returns: Many investors now focus on measures like the Sharpe ratio, which gauges the return per unit of risk, and the companies in the index often offer better risk-adjusted performance compared to their more volatile peers.

4. Investors looking to simplify investment choices: Given the complexity of modern equity markets, selecting individual stocks that combine stability with growth potential can be a daunting task. The BSE Low Volatility Index offers a ready-made solution:

Performance 

BSE Low Volatility Index Funds have given a return of north of 16% over the last 3 years (compounded annual growth rate). Here’s an example of 2 funds that track this index.

Source: AMFI website. Data as of 29 April 2025. 

Note: Past performance is not an indication of future returns.

Conclusion

The BSE Low Volatility Index is fundamentally designed for investors who prioritise stability, risk-adjusted returns, and long-term growth. Whether you’re a conservative retiree looking to protect your nest egg, a long-term investor seeking consistent performance, or an institution aiming to balance a broader portfolio, this index offers a viable option. 

However, as with all investments, it is essential to consider your own financial goals, risk tolerance, and market outlook. Engaging with a financial advisor to explore how this index fits into your broader strategy can help ensure that you make a well-informed decision.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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