Investors should resist the urge to sell out of equities despite the volatility index seeming “eerily calm” amid the current backdrop, according to Schroders’ Duncan Lamont, who said a low VIX in the past has actually been associated with healthy returns.
The VIX, or Chicago Board Options Exchange Volatility index, represents traders’ expected 30-day levels of volatility for the S&P 500 index. As such, it is often referred to as the “fear gauge”.
Perhaps ironically, the index’s historically low reading of 9 - compared to its average since launch of 20 - has made many investors nervous recently as it seems to contradict the swathes of geopolitical and macroeconomic uncertainty hitting markets.
Performance of index since launch
Source: FE Analytics
In an FE Trustnet article published last month, in fact, industry commentators described its movements as “a nagging source of discomfort”.
As Michael Baxter, economics commentator for the Share Centre, warned: “It is often said that markets turn at the moment when all but the most contrarian of investors are on the verge of giving up – a bull market turns sour just at the moment when most bears have been converted to holding more optimistic views.”
However, Lamont argued that investors would have been “unwise” to sell equities on the basis of a low VIX reading in the past.
His research, shown in the chart on the following page, shows the 12-month return of the S&P 500 index in relation to different starting points for the VIX throughout its history. Each time frame is broken up into different percentiles of its history – for instance, the index has been below 11.6 per cent 5 per cent of the time.
“When the VIX has been in its lowest 5 per cent of readings (at a level of 11.6 or less), the S&P 500 has historically generated an average return of 11 per cent over the subsequent 12 months, according to Schroders analysis,” Lamont explained.
“Rather than a foreteller of doom, a low VIX has in fact been associated with quite healthy returns. Not as healthy as when the VIX has been slightly higher but good nonetheless.”
Source: Schroders, Thomson Reuters Datastream
In fact, the head of research and analytics said the worst time to buy has been when the VIX has been relatively high as typically, it spikes when markets are falling.
As such, he said those who have tried to catch the knife when the VIX has been in its 20s by buying in have ended up cutting themselves.
“It is only when investors turn hysterical – when the VIX has been around 30 or higher – that the best returns have been earned by the brave hearted. The old adage that investors should be greedy when others are fearful shines through clearly here,” Lamont continued.
“As with all investment, the past is not necessarily a guide to the future but history suggests that investors would be unwise to make their investing decisions purely on the basis of subdued levels of volatility.”
A recent report from Capital Economics supports the belief that low volatility does not always correlate with the onset of a big market correction. It said investors have been influenced by the fact there was a low level of volatility before the financial crisis so now believe the two to be synonymous.
However, it points out that volatility was even lower during the early 1990s in the run-up to a multi-year bull market.
“A low level of volatility does not cause a correction or mean that one will inevitably occur any time soon,” the report said. “Big corrections are not caused by low volatility, but by unanticipated, unwelcome developments.”
Not everybody shares the view, however. FE Alpha Manager Ben Leyland, who heads up the JOHCM Global Opportunities fund, has been cautious for a while and said his trepidation has increased over the last year.
“We see a market full of stretched valuations and high levels of corporate leverage,” he warned. “These are two key warning signs, as is the level of complacency in markets, as illustrated by the VIX index.
“In that context we think it is prudent to run lower-than-average position sizes and maintain a cash balance in the fund, to protect capital and take advantage of a future pick up in volatility.”
Oliver Clark-Williams, portfolio analyst at FE Fund Research, said the toppy valuations and low volatility levels seen across markets suggest the recent political and economic turbulence is yet to be priced in.
“The prediction of market routs after the Brexit referendum, a Trump Presidency and a hung parliament in the UK have not come close to realisation,” he warned. “Will voters’ chickens finally come home to roost over the next 12 months?”