The argument that market volatility is always bad is not only “outdated” but also “needs to be challenged”, a chief investment officer has said.
The CIO at Triple3 Partners, Simon Ho said that while there are “persistent myths” about volatility, volatility isn’t always something that investors need to protect themselves against.
Further: “By busting these myths, and understanding the true nature of volatility and its impact, investors can benefit from real and sustained portfolio diversification.”
He highlighted the five “most common” myths around volatility.
1. “The market has been very volatile in recent years”
He argued that this is perhaps the “most persistent” myth in recent times.
However: “The VIX Index shows the recent period since 2015 has been the most non-volatile period of the market’s history.”
The VIX Index measures expected volatility on the S&P500 Index over the coming 30 days and high readings mean investors predict “significant risk” that the market will make a sharp move.
“Tracking a synthetic VIX Index that has been created to track back to 1928, we find that market volatility is in fact at 100-year lows. The VIX is at 9, which is unprecedented, it has never been lower. There hasn’t really been a less volatile period since the S&P began.”
He argued that investors “suffer from recency bias” – where portfolio evaluation and future decisions are based on recent results and warned that “media headlines do not help”.
He continued: “While there have been volatility spikes – market movements on the back of unexpected developments such as Brexit or Trump – there has not been an ongoing period of volatility in the market beyond spikes of a few hours, or at most, a few days, during the past few years.”
2. “Volatility is bad for investor portfolios”
Mr Ho rejected this, contending that “far from being bad”, volatility has the ability to “enhance” returns.
Acknowledging that market volatility and falling shares prices can be bad news for long-only investors over the short term, he said that volatility has “emerged as a distinct asset class” and that this warrants different consideration.
He explained: “Volatility has emerged as a distinct asset class in recent years that offers a largely untapped source of alpha that can offset losses in the underlying portfolio.
“As an asset class volatility is good for a portfolio in that it is highly negatively correlated to equities. It can be accessed through the VIX Index with the use of options and volatility derivatives and it affords an investor protection in downturns.”
According to Mr Ho, the average investor is “long on shares and not many short the market”. Noting this, he said market volatility can create opportunities for those who do short the market, and those who make the call on which shares will fall and increase in value.
3. “High volatility equals negative returns”
“With the advent of VIX futures options and exchange-traded products, high volatility does not necessarily mean a negative return for investors,” Mr Ho said.
“The level of volatility tends to be negatively correlated to equity indices, indicating that when equity markets fall, volatility tends to rise and vice versa.”
He said that options on the VIX Index allow investors to access the feature, “which cannot be as reliably harnessed in other asset classes”. He argued that this makes VIX an “ideally suited instrument” for targeting returns that are “negatively correlated to the S&P500”.
4. “Volatility is a good reason to stay out of the market”
To Mr Ho, volatility could represent a great opportunity for investors to “generate alpha” in the VIX options and futures market.
He explained: “The VIX was a brand new product in 2004. VIX options have been one of the fastest growing option markets since then, and these days it is one of the most liquidly traded listed derivatives in the world.
“VIX today is front and centre of the conversation in major markets around the world and volatility options are in fact driving investors into the market. Interestingly, it is retail usage of these products – particularly exchange-traded products — that has driven this seismic growth.”
He also noted that the most popular ETP in the US is a VIX options based product, the VXX.
5. “Volatile markets mean a bubble is forming”
“The exact opposite of this statement is true,” he said.
“Volatility is usually associated with a piercing of the bubble as opposed to a harbinger of the bubble. Non-volatile markets — such as what we are experiencing now — are more likely to indicate a bubble is forming.”
He argued that when there is a lack of volatility in the share market, that’s a sure sign that bubbles are forming in bond markets and with house prices.
Mr Ho said that by debunking myths and better understanding volatility, investors can also understand the impact of fluctuations on their portfolios and the ways they can ride them to produce long-term returns.
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