If you would like to learn more about volatility and how we are using this period of lower volatility to protect your portfolio please get in touch.
Whilst fascination and furore over president Trump has driven the media and the wider public into a frenzy over the past few months, equity markets have been largely sanguine.
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Since the end of February the S&P 500 (the best indicator of US equity performance) is pretty much unchanged.
During this same period, we had a French election, a near nuclear war with North Korea and a direct US attack on Syrian forces. In essence, Trump made good on Obama’s red line, the French nearly destroyed the EU and both Koreas were nearly wiped off the map. Yet despite all this the VIX, a measure of volatility within US equities, declined to it’s lowest level in a decade.
Not market moving nowadays….
Why?
To understand the decline in volatility and the VIX one needs to understand exactly how the VIX works and exactly why it would decline during this period. Despite the media frenzy surrounding Trump, yields and rates still remain relatively low.
Just to keep everyone on the same page, yield (the interest rate) is the return an investor will receive in return for buying a bond. Whilst yields are low investors will naturally look for other areas to generate a ‘safe’ return. This has had an enormous amount to do with why yield-like equities with strong dividends have performed as strongly as they have.
One such way an investor can generate a return is through selling an option. Selling an option produces a return. As long as the underlying equity or instrument does not approach the relevant strike, these options expire worthless and the option seller keeps the premium they sold, achieving their desired outcome.
The risk to investors arises when these options sellers get caught selling options and an event takes them by surprise.
This can happen at any time and the results are an explosion in the VIX. See below.
Sellers of volatility are suddenly in deep trouble on a spike here.
In August 2015 the Chinese significantly devalued the Chinese Yuan, sending shock waves around the investment community that China was about to start exporting (through a weaker currency) deflation to the rest of the world. The move in equity markets was large and was exacerbated by a meltdown in the ETF* market (an event still denied by ETF providers) and the spike in the VIX was enormous, moving from around 12.5 to over 50 in a few days. If you had been caught selling options on the wrong side of that you could have lost the house.
*Exchange Traded Fund
Keeping the metaphors simple today…
So does this impact markets right now?
Not in a significant way. Volatility tends to stay low for a very long time but when it does move you need to be careful not to get caught on the wrong side of it. It is an interesting phenomenon that has developed over the past 5 years though and goes to show that despite what have been characterized as an incredibly tumultuous number of months markets have largely done their own thing.
There will at some point be a period when investors need to be aware of what has happened and why it has happened. Further exacerbating this ‘low volatility’ period have been moves to adopt portfolio strategies which base asset allocation around the current level of volatility. Put simply, certain strategies are leveraging up their exposure to equities whilst volatility is low on the mistaken belief that lower volatility means that excess leverage is justified.
If you would like to learn more about volatility and how we are using this period of lower volatility to protect your portfolio please get in touch.
All the best,
The VFS Global Macro Fund
Level 30 Australia Square, 264 George Street, Sydney NSW 2000
+1300 220 360 | gmf@vfsgroup.com.au | www.vfsgroup.com.au
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