Evidence and Attributes of Low Risk Investment Strategy

Abstract

Assuming investors act rationally and therefore markets run efficiently, modern portfolio theory states that newlinehigher-risk assets should earn higher returns than investments in low-risk assets. But in fact, many studies newlinesuggest that low-risk assets earn higher returns over the long run, called the low-risk effect. This research newlineexamines the prevalence of the low-risk effect in the Indian equity market. It studies the stocks listed on newlinethe National Stock Exchange of India from January 2000 to September 2018. The study shows that the least newlinerisky portfolios generate higher risk-adjusted returns than their counterparts and the market index. They newlineearn economically and statistically significant alphas and the effect is not an overlap of any stylized factors. newlineThe study decomposes the low-risk effect into its micro and macro components and observes that investing newlinein low-risk stocks within a sector (micro) contributes more to the low-risk effect than investing in low-risk newlinesectors (macro). The alphas of long-short and the long-only low-risk portfolios within sectors are positive. newlineTwo of the highest contributors to the returns to the low-risk portfolios are stocks from consumer staples newlineand materials sectors. In the developed nations, utilities and the real estate sector contribute more than 50% newlineto the low-risk effect, but these sectors contribute minimally in India. The magnitude of sector betting is newlineaverage 10% and has reduced to 3 -4% in the recent period in India, while in developed markets, it is newlineaverage 25%. Thus, the low-risk effect manifests differently in India than in developed markets. The study newlinealso examines the theories that drive the low-risk effect in India. The factors created to explain the theory newlineof leverage constraints deliver robust returns than the factors created to explain the demand for lottery newlinestocks. While in developed nations, both the competing theories explain the persistence of the low-risk effect, in India,the theory of leverage constraints dominates in explaining the prevalence low-risk effect