Is Low Volatility a Risk or an Opportunity for Investors?
Solid economic growth and low interest rates have pushed financial market volatility to multiyear lows. Has volatility been tamed for good or will we see a gradual return to higher market volatility levels? And what is the impact on investors’ returns?
Aside from some short-lived turbulence, financial markets have been exceptionally calm over the past year. Until recently, equity markets have followed a stable uptrend, economic growth has been healthy, inflation has been low, and many central banks have maintained their accommodative monetary policy.
The result is a market in which volatility is at a multiyear low. The Volatility Index (VIX), a key measure of expected US equity market return volatility, has essentially been hovering at a very low level of only 10% this year and last, while the long-term average of the VIX is closer to an annual volatility of 20%.
While major events like the Brexit vote and the election of Donald Trump last year, as well as the recent escalation of the rhetoric between the US and North Korea, have triggered spikes, volatility has quickly reverted to previous low levels.
Volatility Moves in Cycles
Unforeseeable events triggering an abrupt deterioration of investor sentiment and leading to an increase in risk premiums and implied volatility levels can always occur. However, there are fundamental reasons that appear to hold volatility levels down: The availability of liquidity and the ability of companies to absorb shocks are key long-term drivers of financial market volatility.
As central banks are likely to retain an accommodative monetary policy stance and companies have improved their liquidity ratios, both these factors support a continuation of the current low volatility regime, short-term volatility spikes aside. An eventual sustained tightening of monetary conditions would however see volatility starting to increase gradually and more sustainably.
Is Low Volatility Just the Calm before the Storm?
The question arises as to whether a return to higher market volatility would imply an increased likelihood of an economic crisis or a market correction? Bloomberg recently published an article on how the lack of volatility could be interpreted as the calm before the storm. There is historical evidence of low volatility periods between crises, such as the one prior to the financial market crisis of 2008.
However, as the VIX is a reflection of uncertainty in the markets, it is only natural to expect rising levels of volatility if a full-fledged reversal of monetary policy to a more hawkish stance were to occur – especially if this change were to be communicated poorly by the central banks.
However, such a development alone does not mean that we would immediately face a crisis, provided the long-term factors that support low volatility regimes, namely the availability of liquidity, modest corporate leverage and companies’ ability to service their debt, remain in place.
Return and Risk Increase in Step with Volatility
Every investment decision entails a combination of risks and opportunities. Volatility captures both in a standardized measure. An increase in volatility not only means that risks increase, but also that return opportunities increase, which results in a broader spectrum of possible outcomes.
Many investors are wondering whether they should hedge their investments or enter the market now. Even though volatility levels offer specific opportunities for certain strategies, long-term investors should primarily make sure that they are invested at all times. The simple reason is that bad timing can substantially reduce returns – even over a long period of 14 years.
An example shows that investors between 2003 and 2016 would have achieved a much lower return had they not been able to use the five best days on the equity market: A long-term investor fully invested in the STOXX Developed Markets 150 from December 31, 2002 to December 31, 2016 would have achieved a return of around 150 percent in US dollars during those 14 years. Had they missed just the five best days (for instance, due to selling five days prior), their total return would have only been 63 percent.
Investment Opportunities in a Low Volatility Environment
The current below-average levels of financial market volatility provide interesting opportunities for investors. Investors who want to enter the market can take advantage of low volatility to purchase a combination of upside participation in equity markets with limited downside risks. This stabilizes (or partly hedges) the portfolio in times of higher volatility, while still providing upside.
For investors who are nevertheless reluctant to enter the equity market «full throttle», there are structures available that allow systematic, staggered market entry, taking advantage of market setbacks to build up positions and average out the initial investment while the “cash” part offers an attractive interest rate.
Last but not least, hedge funds allow access to even more market segments, strategies and instruments, which ultimately act as a diversifier to most portfolios due to their low correlation to traditional asset classes.