Tuesday, 4 August 2015

How to profit from volatility

Relentless easy monetary policies and short-term bank rates at virtually 0% have kept market volatilities at remarkably low levels for the past few years. Preparing for the next spike may not be such a bad idea, as the effects of central banking measures start to wane.

The financial world has entered unchartered waters in the past years with high levels of monetary easing skewing markets and volatility alike. More precisely, the ongoing central bank interventions, a significant belief in quantitative easing and a lack of alternatives have significantly influenced asset flows.

More than an estimated 80% of global equity market capitalisation is located in countries in which central banks have kept interest rates at virtually 0% or where they have even slipped into negative territory. A lot of funds have been rotating into equities, driving up indices with only very moderate and shallow pull-backs meaning equity volatility has been reigned in.

Fear-indicators of equity risk such as the VIX, which measures the implied volatility of S&P 500 index options, have been moving through a long trough ever since the last spike in 2011. Back then, a possible Greek default had unleashed a market correction and provoked a sudden spike in volatility. But ever since ECB head Mario Draghi’s infamous promise to “do whatever it takes” to save the euro, things have clearly changed. Due to the lack of alternatives to equities, investors have possibly become somewhat complacent. 

Demand from institutional investors for some form of protection against a possible return of volatility has picked up. ETFs that track the VIX are one of several possibilities. These funds typically move in the opposite direction to the broader market indices and are therefore used primarily by investors who want to capitalise on volatility spikes following sharp market pullbacks.

However, timing is critical, as these instruments lose with every rollover during periods of stable volatility. Volatility ETFs, which invest in volatility futures, are often being seen as a hedge tool when volatility spikes, but the opposite can be true. That is because of ‘contango’, where by contracts further along the futures curve are more expensive than current month contracts. That in turn would not always lead to the desired result, since timing can work against them, which is precisely why some investors are opting for different insurance methods. 

Current low volatility levels offer a cheap opportunity to buy some portfolio insurance by way of purchasing put options. Being a little on the safer side may not be such a bad idea at this point as equity valuations, although not at extremes, have reached a point where any bad news could provoke a small market correction.

Other clients, however, are taking on more risk and are also more willing to sit through short-term turbulences as a trade-off for higher long term performance. We are advising clients to take some risk off the table and to consider alternatives such as real estate, absolute return funds or long/short funds within both equity and fixed income.

That is not to say that volatility may not spike at some point in the future as there are possible triggers such as an unexpected event on the geopolitical landscape or a worsening of the Greek debt situation. How far down the road a serious sell-off may actually lie, obviously remains to be seen – this is why it may not be such a bad time to start thinking about some form of protection against any return of volatility. As always clients should seek advice on the suitability of an investment for their own circumstances where appropriate from a professional advisor.

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