The Death of Volatility
Simon Twiss, Partner, Equity Dealer
Headlines abound extolling the death of volatility. Given the record run of ten days where we saw the VIX (CBOE SPX Volatility Index) trading below the historical lower bound of 10, we take the time to step back and examine some of the forces driving volatility lower.
An important starting point is to acknowledge that realised volatility has in fact been historically low. Somewhat counterintuitively, the realised volatility has been lower than future volatility implied by options prices (implied volatility). Interestingly, a handful of fortunes have been made exploiting this strategy (selling low implied volatility but then realising even lower levels) over the last few years. The 10 day S&P500 realised volatility closed at 2.3% on the 2nd of August, the lowest level in VIX history which started trading March 2004.
Ironically, the scientific definition of volatility is the “tendency of a substance to evaporate at normal temperatures.” With a liberal dose of poetic licence, we extend this analogy to the world of financial instrument volatility, which has indeed evaporated (see Figure 1: the VIX and the local ASX200 VIX). What we need to consider is how “normal” are these financial temperatures and how long can they be sustained.
Volatility can be characterised as the cross section of a supply of surprises (shocks) and the susceptibility (vulnerability) of these markets to said exogenous shocks. Again, back to physical systems, the shock and the ability to withstand the shock and return to homeostasis. High volatility tends to occur at periods of high stress, uncertainty, fear and anxiety. On the contrary, low volatility occurs during sustained market rises and when emotions are calm, content and relaxed.
We will consider this framework when looking at the factors we think are currently impacting global volatility. Global economic uncertainty remains at elevated levels. Geopolitical tensions are increasing from factors like militarisation of the South China Sea, North Korea, Syria and the Philippines, as well as the looming spectre of terrorism. U.S economic policy can do an about face at the speed of a 140 character tweet from the @POTUS. There has been no short supply of surprises to the market.
When reviewing the ability of the market to sustain such shocks we have to remember that volatility relates to both positive and negative shocks. However given the move of central bank balance sheets into bonds and notably now into ETF’s (and direct equities in the extreme case of Japan), the lender of last resort now has a semi-permanent seat at the table.
However, we expect central banks to be very sensitive to the ramifications of their policy actions, thereby limiting downside tail risks, creating an asymmetric market. Active managers in bonds and equities have effectively been crowded out in the shift to passive, by ETFs in the instance of equities and more so Central Banks in the bond market. We can see this below, where the global tradeable bond universe is proxied via Bloomberg / Barcap indicies, which stands at $54tn as of April 2017. The percentage ownership held by central banks is large, and larger still when combined with commercial banks.
This is even more staggering when we look at a % of GDP across the world.
Source:  BIS, NBER
This is fine in an environment where stocks move more or less in lock step, meandering higher. The test for this new market microstructure will come when these large price agnostic funds begin to reduce positions or need to sell into falling markets.
We note active managers generally outperform during periods of volatility and negative absolute returns. The first chart below refers to the relationship between volatility and dispersion of returns. The second chart relates this cross sectional volatility to active management.
Return dispersion is higher when stock market volatility is high i.e. when there are stock market downturns. The fact that active managers outperform when return dispersion is high (second figure) leads to an important observation for investors with an active manager: These investors should be better protected during market downturns and should therefore experience less sequencing risk than a passive investor.
Finally, another factor that impacts the ability of markets to absorb shocks is trading liquidity. This has undergone a secular decline since the GFC and the introduction of Dodd Frank, which came with increasing bank capital requirements designed to reduce proprietary and risk trading capital. The removal of this liquidity would not reduce volatility.
As we can see in the chart below, turnover has declined in both developed market equities and bond markets. The turnover ratio is annualised, that is based on monthly trading volume divided by the outstanding stock of each asset. The confluence of these forces has led to a systematic lowering of volatility. The question as to how long for remains to be seen.
At the time of publishing, the VIX had spiked 46.35% to finish at 16.04.
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