Investors have not shied away from equities, despite the expectation that near-record low volatility might be due to turn soon
• US equity market volatility has receded to near-record lows as US equity indices continued higher.
• The lull in volatility reflects factors that typically occur late in an economic cycle when there is low risk of recession.
• Investors are sticking with equities but taking defensive measures through put-selling strategies and avoiding high-volatility stocks.
Franklin Delano Roosevelt, speaking in his 1933 inaugural address as President of the United States, famously said that Americans had nothing to fear but fear itself. If he was in a position to comment on today’s US equity markets he might declare in contrast that there is nothing to fear but the absence of fear.
Equity market indices in the US have only edged slightly higher despite domestic and global threats ranging from repeated missile tests by North Korea to investigations of the Trump Administration that threaten to derail the new president’s pro-growth agenda. On the economic front, US growth data showed a mixed picture, raising concerns about the strength of the recovery, even as the Federal Reserve readied more rate hikes.
Yet, despite ample evidence of situations that could turn into destabilising events, fear seemed to have headed for the summer holidays a bit early, as US equity market volatility receded to near-record lows while US equity indices continued higher.
In early May, the VIX index, which measures the expected volatility of the S&P 500, fell to 9.8, the lowest level since 2000 and near the record low of 9.3 touched in 1993, according to Capital Economics. The average level of the VIX since the start of its time series in 1990 is 19.6.
Ask institutional investment managers how they spell trouble and the answer is likely to include a reference to what happens after such a period of low volatility. While refraining from predicting a substantial correction – and noting that the low level of volatility is not unique by historical standards – numerous managers tell IPE they expect a return to more typical levels of volatility, and sooner rather than later.
According the VIX futures curve, traders expect equity volatility to revert to trend levels within the next 60 to 90 days. A reversion to the mean from recent lows could be a substantial increase of nearly 15% in volatility. In the meantime, managers have adopted several strategies for coping with – or benefitting from – the waxing and waning of investors’ risk appetites and their expectations about equity volatility.
In fact, some contend, the current environment is more indicative of the financial characteristics that investors are looking to equities to provide than of any macroeconomic views. “The problem with low volatility is that it tends to be subsequently followed by periods of high volatility,” says David Purdy, a vice-president and portfolio manager at Acadian Asset Management. “When you have indices marching upwards towards highs, realised volatility in the indices can be fairly low,” he adds. “Current valuations of high-volatility stocks indicate that investor sentiment for taking on additional risk is also low.”
When appetite for risk is low, Purdy explains, defensive characteristics such as quality of earnings, growth or profitability tends to take more credence in the mental models of investors, and the appeal of value characteristics recedes. The challenge for managers and their clients, he says, is “to position the portfolio in a way that will be consistent with investors’ shifting sentiment”. In Purdy’s view, “investors will likely become much more risk-averse as volatility rises, given that they’re already risk-averse today”. That, he adds, “is going to be a headwind for value, and a tailwind for quality and growth”.
Faced with the difficulty of handicapping when those factors will come in and out of favour, investors opt for various strategies to hedge against volatility. “Controlling volatility is a business,” says Douglas Kramer, co-head of quantitative and multi-asset class investments at Neuberger Berman. But it is an expensive proposition, he explains. The clearing price of volatility control can be found in two instruments, S&P 500 put options, which allow investors to buy downside protection on the market explicitly, and the VIX market, which is less closely correlated with equity directionality than equity put options but, nonetheless, a good hedge.
“When you look at those two markets you see a very expensive way to hedge yourself,” Kramer says. The cost, he says, of buying downside protection on the S&P 500 for 30 days over the long run is about 1.5% a month or 18% on an annualised basis. “If you want to take your mark-to-market risk off your books, and put it onto somebody else’s books, you have to pay a very heavy price.”
But therein lies an opportunity. “If something’s expensive, what are you supposed to do with it?” Kramer asks rhetorically. Neuberger manages a strategy that sells put options on equity indices, including the S&P 500 and the Russell 2000, fully collateralised with cash or Treasury securities (see box, left). The systematic put-selling captures the insurance premia paid by investors that must protect portfolios against volatility. “There are investors that behaviourally or structurally need to buy these options to avoid the chance of loss,” Kramer says. For example, institutions that have value-at-risk limits, such as banks that must demonstrate to regulators that they are not exposed to losses in financial stress scenarios.
Another approach is to monitor the volatility characteristics of the financial results of companies held in an equity portfolio, says Bill Tilford, a portfolio manager in RBC Global Asset Management’s global low volatility team. “Our focus is preserving capital in down markets,” says Tilford. “The quality of the financials, such as the volatility of accruals, and volatility in the profitability of the company, taken together, do a good job of forecasting future volatility of a stock,” he says. The aim, he says, is to distinguish businesses with sustainable fundamentals from stocks being supported by momentum. “From our investment perspective, it’s important to remember the difference between a good company and a good stock.”
When volatility might return to its long-term trend is subject to debate. One clear indication comes from the VIX futures market, says Kramer. Based on prices in late May, VIX futures indicated that investors expect the VIX to reach 13 by July, compared with the spot market level of 10.6 at the time. The difference between the spot market VIX level and the first forward contract in June was about 8% – a sharp increase in expected volatility over a very short period. “The volatility markets are already pricing in mean reversion,” Kramer says.
In fact, the recent lull in volatility reflects factors that typically occur late in an economic cycle when there is low risk of recession, says Eoin Murray, head of investment at Hermes Investment Management. While macro conditions could be interpreted as benign, leading to investor complacency, Murray says, “the VIX has never under-priced political or policy uncertainty by as much as it is today”. A key reason, he says, is that central bank asset-buying has conditioned investors to buy dips. “Market shocks are seen as alpha opportunities rather than marking the onset of uncertainty,” he adds. This behaviour is “supported by the low rate environment, in which nothing seems particularly scary.”
A sudden move towards historical levels of volatility might yet prove scary. But despite the message from the VIX futures market, that reckoning may be some time off. An old market adage holds that bull markets climb a wall of worry, and that seems to be the case today. “It’s clear that investors are expecting, at some point, a rise in volatility,” says Acadian’s Purdy. “They’re willing to ride the equity market for now,” he adds, “but they’re doing it in a defensive crouch.”
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