Eerily quiet

Investors and market participants are becoming increasingly concerned about the low levels of volatility in financial markets. This may seem strange as low volatility should help investors sleep at night. However, if low implied volatility signals that nobody is worried about potential shocks or turbulence, it can lead shrewder observers to question the consensus.

So, what is volatility and how is it measured? The commonly referred to ‘VIX’ index is often known as the ‘fear gauge’ and represents one measure of the Standard & Poor’s 500’s expectation of stock-market volatility over the next 30-day period. The VIX aimed to create a stock-market volatility index based on index option prices. Other measures are used to track the volatility of different assets. Citigroup recently noted that the volatility of its ‘economic surprises’ index for the world’s largest economies had hit
a record low.

Potential explanations for the low volatility being witnessed are varied. They include accommodative monetary policy and intervention from global central banks, and a reduction in the trading activities of large investment banks. Quantitative easing in the US and UK has also helped dampen volatility in bond markets, which has, in turn, fed into equity markets.

However, some commentators feel that market expectations of interest rates being ‘lower for longer’ may be misguided and if economic data in the west continues to improve, these expectations could be tested sooner rather than later.

The VIX index is currently hovering around a seven-year low: reason in itself to be concerned as this level was previously attained prior to the financial crisis in 2007. Robert E Whaley, a professor at Vanderbilt University’s Owen Graduate School of Management, who is known for developing the VIX for the Chicago Board Options Exchange in 1993, doesn’t appear overly concerned, though. In a recent interview, he said the low reading just means investors are comfortable that nothing significant will happen in the next 30 days.

Potential up-tick

Those more concerned about a potential up-tick in volatility may look at products that aim to track the VIX and benefit from an increase in market turbulence, potentially offsetting losses in other areas of their portfolio. Guy Stern, head of multi-asset and macro investing at Standard Life Investments, recently asserted that volatility is an attractive asset class and one he feels is relatively cheap to where it has been historically.

However, history shows this type of investment in volatility exchange-traded products is not without its risks as a buy and hold strategy in these products is almost guaranteed to lose money over time. Drawbacks include the high cost of trading, and rebalancing of strategies, as managers must reinvest or ‘roll’ holdings into new contracts, which erode returns.

The fact that investors in these products are buying securities created using futures strategies on the VIX, not the VIX itself, is another. Used successfully, volatility products can help capture positive performance in an environment where traditional asset prices are falling. However, it is imperative investors understand what they are buying and
the potential pitfalls of doing so.

While events such as civil unrest in Ukraine, a slowing of growth in China or an increase in interest rates in the US or UK could stoke fear in markets, volatility can be useful to investors with a longer-term time horizon. It often presents opportunities in mispriced investments that have been hurt because of sentiment rather than a change in underlying fundamentals. This can
mean that all things being equal, investors can pick up the same
quality asset at a cheaper price.

The key is making sure the asset quality and investment thesis remains intact and when asset prices are falling and volatility is rising, this may be
easier said than done. As long as the economic and corporate recovery
remains supportive, the next bout of uncertainty may provide attractive opportunities, and if history is a guide,
we shouldn’t have to wait too long.

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser