Calculation of smallcase Volatility: New & Improved!

Changing stock prices on a daily basis results in fluctuations in the investment value of your portfolio. Rapid changes in the investment value of your smallcase would result from changes in the prices of stocks within that particular smallcase. Such smallcases are said to have high volatility.

Currently, every smallcase is categorized into one of the three volatility buckets – High, Medium and Low Volatility. This is done by comparing smallcase volatility against that of the Nifty 100 Index.

Volatility is calculated based on live data only. This means that no backtested data is taken into consideration while calculating volatility.

How was volatility calculated until now?

To understand why we’re updating our logic, first, let’s understand how we’ve been calculating volatility for smallcases until now –

For smallcases which have been live for more than a year,

Volatility Ratio (VR) = a/b where
a = Average (Rolling 1y standard deviation of a smallcase’s daily return since launch)
b = Average (Rolling 1y standard deviation of Nifty 100’s daily return since launch)

The volatility was then mapped such that for smallcases with VR >= 1.3, the High Volatility label was displayed; for VR >= 0.8, but less than 1.3, the Medium Volatility label was served; and finally, for VR < 0.8, the smallcase was marked as Low Volatility.

However, if the smallcase has been live for less than a year, the weight of equities in a portfolio was taken into consideration –

If the weight of equities in the portfolio was less than 40%, the smallcase was assigned the Low Volatility label; for anything between 40% to 70%, the smallcase was assigned the Medium Volatility label.

If the weight of equities in the portfolio was greater than 70%, then the weight of large-cap stocks within the equities portion was taken into consideration. In this case, if the weight of large-cap stocks within the equity portion was more than 70%, the smallcase was assigned the Medium Volatility label; and for less than 70%, the smallcase is assigned the High Volatility label.

For smallcases where the manager had not prescribed any weights, equal weights were assumed for calculations.

What was the issue with the above method of volatility calculation?

Currently, the algorithm was designed such that if a smallcase exhibited low volatility in the initial years of the launch, but had been experiencing very high volatility recently, the volatility labels will continue to show low volatility for a long time, as no additional weight was given to the recent volatility patterns.

Technically speaking, the algorithm gave equal weightage to all the data points while calculating the average annual standard deviation for the smallcase and the Nifty 100 index, before calculating the volatility ratio.

After speaking to investors on our platform, we realised that giving slightly more weightage to current behaviour can be beneficial while judging a smallcase. After much thought, here’s how we’re updating the logic for the calculation of volatility for smallcases.

How will volatility for smallcases now be calculated?

If the smallcase is more than 1 year old –

Volatility = a/b where

a = [0.7 *Average(Rolling 1y sd of smallcases daily return for last 1Y) + 0.3*Average (Rolling 1y standard deviation of smallcases daily return since launch except last 1Y)]
b = [0.7 *Average (Rolling 1y sd of nifty’s daily return for last 1Y) + 0.3*Average (Rolling 1y sd of nifty’s daily return since launch except last 1Y)]

This is expected to make the volatility label more responsive to recent market trends and solve for any previous concerns. The volatility ratio so obtained will be mapped to labels by using the below table:

If the smallcase is less than 1 year old –

If the weight of equities in the portfolio is 

• less than 40%, the smallcase will be assigned the Low Volatility label
• between 40% to 70%, the smallcase will be assigned the Medium Volatility label

If the weight of equities in the portfolio is greater than 70%, then the weight of large-cap stocks within the equities portion is taken into consideration. In this case, if the weight of large-cap stocks within the equity portion is 

• more than 85%, the smallcase will be assigned the Medium Volatility label
• less than 85%, the smallcase will be assigned the High Volatility label

For smallcases where the manager has not prescribed any weights, equal weights will continue to be assumed for calculations.