TitleSenior Investment Analyst
DateFebruary 19, 2018
As the market fell into a panic in February, those listening carefully may have heard the quiet sighs of relief from equity managers, writes Shailesh Jain.
When it comes to market volatility, how can you tell if fear is outpacing reality? The first place you might look for an answer is the spread of implied over realised volatility. Implied volatility is measured by the famous (or perhaps infamous) VIX, which is based on the market’s pricing of options and represents the expected range of movement in the index. Realised volatility, by contrast, is the actual range of movement based on historical prices. So implied volatility is what we expect, while realised volatility is what we get.
When forming expectations of the future, investors will naturally anchor their assumptions in recent experience. For a long time, investors have had little reason to fear the future because of a very favourable past, and this has been reflected in the VIX price. It is worth noting that, over the past ten years, implied volatility has been consistently higher than realised volatility, but what helped to drive the VIX to its all-time lows in late 2017 was the persistently low levels of realised volatility.
As the chart below shows, realised volatility for the ASX 200 has been falling since around the start of 2016, when large falls in the Chinese market and the devaluation of the Yuan threw global markets into a panic. The ASX 200 VIX also fell, reaching an all-time low of 8.83 in March 2017, before spiking in February 2018 during the most recent bout of panic. The picture looks much the same for the All Ordinaries Index, which includes small cap shares.
The VIX has hovered in the low double digits for stretches of time since October 2012, hitting one of its lowest levels in early January 2018. Moderate increases in equity volatility over this span have been accompanied by equally short-lived equity market drawdowns. These sell-offs have occurred as part of an overall upward trend in the index (see the chart below).
Even in light of the recent spike in volatility that appeared to wrong-foot investors in February, fundamentals still provide some support for a low volatility environment. Interest rates are still at ultra-low levels, investors are benefiting from excess liquidity, corporate credit fundamentals remain strong, and the global growth outlook is positive. Nevertheless, there is something reassuring about the return of volatility. Even though almost one half of the market fall has been recovered, investors are still on edge, and this might not be such a bad thing.
Based on our conversations with fund managers, the continuing lack of volatility in markets through 2017 became quite unnerving, especially for those within the Lonsec Australian Equities and Small Cap Equities universe. A number of managers, fearing that markets had become complacent, decided to err on the side of conservatism by holding a higher cash weighting in their portfolios. Most managers were of the view that low volatility can lead investors and traders to do things that make the financial system more fragile and vulnerable to crisis. After a decade of quantitative easing, investors may also have worried about the market’s ability to effectively perform the price discovery function.
While not necessarily saying that a massive bear market was on the horizon, many managers did raise a few red flags, noting that stocks are particularly vulnerable when a low-volatility environment comes to a grinding halt. Valuations may still appear on the expensive side, even after the most recent correction, and there are no immediate signs that the insatiable demand for yield and leverage has passed. But what it could possibly signal is a gradual return to more ‘normal’ economic conditions, with investors now concerned about the prospect of rising inflation, and even the need for central banks to hike rates quicker than anticipated.
Hence the market’s ambivalent reaction to the sudden market downturn, and the quiet sighs of relief from some managers that markets are still capable of checking (even if in somewhat dramatic fashion) the seemingly inexorable rise in equity values. While periods of low volatility do not consistently telegraph market direction, markets do eventually revert to normal volatility levels. Lonsec notes that a rise in volatility does not, by itself, signal major losses for equity investors, especially if it occurs at a measured pace.
What this means for future movements in volatility (and indeed the future direction of shares) is not entirely clear, but if the recent volatility spike is followed by a more gradual movement higher in volatility, there is not necessarily any reason for investors to flee to cash. In fact, a measured rise in volatility could be conducive to active strategies that are driven by stock selection and managed by skilled portfolio managers. In other words, investors will need to stop relying on the beta rally and start looking for opportunities.
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