What the Return of Volatility Tells Us Going Forward
by Charles Cheng, CFA
The dramatic market drops at the start of the month of February after around two years of steady advances were a reminder to investors to continue to pay close attention to possible downside risks to their portfolios. From the time when world equity markets peaked on Jan 26th to the lowest market close on Feb 8th, there were few safe havens as most major asset classes fell significantly. During this period, the S&P fell -10.1%, the MSCI developed market index fell -9.0%, the MSCI Emerging Markets index fell -8.6%, Gold fell -2.8%, the US Corporate Bond Index fell -1.2%, and intermediate dated US Government bonds fell -1.4%. We cover some of the lessons that Investors can take away from the experience.
Use history as a guide to potential market moves
If this correction felt familiar, it was because a very similar one happened less than five years ago. In May of 2013, after a long period of steady gains, markets were spooked by the prospect of the US Fed removing accommodative monetary policy. Similarly, the February 2017 correction was initially triggered by US Treasury yields moving higher in response to an economy that is heating up and continuing stimulus from the US government (see “Expert’s View”, Dec 2017), in anticipation of the US central bank tightening policy. In both corrections, traditional safe haven assets such as government bonds and gold joined in the sell off. The 2013 correction turned out to be short lived as the fears of the effect of tighter money turned out to be overblown.
Don’t over-extrapolate recent history
A key story during the recent sell-off was of the implosion of “inverse volatility” products. Essentially, these were bets that volatility (as measured by the index “VIX”) would remain near historical lows, as it had been for the past two years.
The products had gained popularity in recent years as investors believed that the downtrend of volatility would continue indefinitely. When the volatility index soared from 10 to around 50, the exposure to volatility was so high that many of these products lost over 90 percent of their value and were forced to liquidate.
However, if investors in these products had done their research or were adequately informed, they would have realized that VIX has had a similar sudden spike to 50 as recently as 2015.
Try to consider the amount of risk you can take before anything happens
With an understanding of what has happened before in financial markets to guide investors on what could happen, it’s important to have maintained an investment exposure level that reflects the maximum loss that they are willing or able to take. If an 8-10 percent loss in roughly a week (or much higher, depending on which instruments you are using) would cause you to alter your investment strategy or be forced to sell off assets, then you were taking too much risk to begin with. This is especially important for investors that trade on margin, where the selling decision could be left up to their brokers. While leverage within acceptable limits may enhance portfolio returns, too much may permanently impair any long term investing plan.
Mr. Cheng is a managing partner at Clarity Investment Partners, a Hong Kong based independent private investment office.