Analyses and investment views

Dangerously low volatility

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“Stability begets instability.” Those are famous words of the American economist Hyman Minsky. What did he mean by that? A long enduring period of stability in markets or in the economy encourages market participants to undertake greater and greater risks, so much so that this in and of itself causes a state of instability which then contributes to a substantial drop in the prices of various assets.

Today, we are in a situation very much of that sort. Historically low volatility on equity markets is sending out false signals as to the level of general risk. Investors have the impression that risk is low and they are taking more risk into their portfolios than they presume. Risk is an inseparable component of every investment. If, however, an investor uses an erroneous definition of risk (and volatility is one such definition) and at the same time incorrectly regards its level as low, then he or she may be on a collision course with trouble.

What is volatility anyway? It is a statistical variable that measures the rate of fluctuation in an asset’s price. The more the price of a stock or index value fluctuates, the more volatile that price or value is. There are two kinds of volatilities: implied and realised. Implied volatility displays investors’ expectations concerning future volatility. It is calculated from option prices using the Black–Scholes model. Realised volatility states an actual rate of price fluctuation in the past.

Both of these volatilities have recently been at historic lows. Implied volatility (as measured by the VIX index) has been calculated since 1990. Its average value between 1990 and 2016 was approximately 20. This year’s average is close to 10. In all of its 27 years, the VIX has slipped below 10 only about 50 times, 40 of which occurred this year. This year’s realised volatility dropped to as low as 7, and that makes 2017 the least volatile year for the entire time that volatility has been measured.

Now, two questions come to mind here: Why is volatility so low, and why should it matter? I have no answer for the first question, but I do have one for the second. We can only speculate why volatility is at record lows. I personally think that there are three main reasons. The first is based in the long period of rising equity markets. Volatility is usually lower when markets are rising. The second, relates to the booming popularity of passive investing. When fewer and fewer people give any thought to what they are buying and at what price, this tends to diminish the volatility of the individual share prices and of entire markets. And third, massive bond purchases and interest rate manipulations by central banks have decreased volatility in interest rates and that is working its way through to the volatility of stock prices.

The question why low volatility should be bad, however, is much more crucial. It all relates to the definition of risk and its management. The vast majority of institutional investors still steadfastly use volatility as a measure of risk. This, then, would mean that historically low volatility in their sophisticated risk management models (such as Value-at-Risk) is signalling that their risk is too low and that their “capacity for risk” is not being fully utilised. Having unfulfilled capacity for risk is a terrible thought for many investors. Fortunately, there is an easy remedy at hand: take on more risk. One can always bring more risky assets into one´s portfolio and use more leverage.

That is exactly what we are seeing today. All robo-advisers, quant investors, risk parity funds, funds targeting a specific level of volatility, ETFs shorting volatility directly, and the like are taking on more and more risk. There are plenty of such products based on low volatility, and the sum of money invested into them will be not just in the hundreds of billions of dollars, but probably by an order of magnitude still higher. Shorting volatility is hidden from the common investor, but it is now a widespread mania.

All these investors implicitly assume that low volatility will remain with us also into the future. That, however, is not probable. Even a mere return of volatility to its long-term average would mean a 100% increase in the VIX index. That is by no means unimaginable. Moreover, volatility usually jumps up quickly and unexpectedly but diminishes gradually. Such upwards movement in volatility would cause massive corrections (i.e. selling) in many portfolios, due in part also to margin calls. Risk capacity would suddenly be exceeded substantially and positions would need to be radically reduced. These sales would cause a still greater increase in volatility, which would cause even larger sales, et cetera.

Betting on low volatility, whether of the explicit or implicit sort, has been paying off recently, and it can bring concrete returns. Those gains come, however, at the price of very high risk. Endeavouring to continue with this strategy also requires undertaking increasingly large risk. Careful and conservative investors who define and value risk correctly and hold themselves back may now look to many like poor investors. Responsible money management is not highly valued in times such as these. It is just these careful investors, however, who will have the last laugh. Today’s risk-takers will run into big problems sooner or later, and in hindsight they may themselves be surprised how much they put at risk. In certain cases, these problems will be existential. This is the case especially of certain ETFs which are shorting volatility, have built-in leverage, or invest into illiquid assets. Some of them will perish and take their investors’ money with them.

Keeping a cool head in the midst of a crowd that is pursuing quick profits regardless of the risk involved is often the hardest thing for investors. It always pays off in the end, though.
Invest with care!

Daniel Gladiš, 11 December 2017


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