Investors should be re-evaluating how they think about risk after an unprecedented period of low volatility, according to BlackRock fund manager Nick Osborne. 
Earlier this week, FE Trustnet noted that The CBOE SPX Volatility index – more commonly known as the VIX – has been trading at historically low levels in recent months.
The VIX – seen as a key barometer of investor sentiment and market volatility – measures the market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
But investors need to consider the amount of volatility they are happy to take on if and when markets normalise, according to Osborne.
“There are a number of things that you could point to that heighten the risk of volatility,” the manager said.
“One of them is clearly valuation – we know that bonds are at valuations that appear very high relative to their own history.
“Equities appear less extremely valued but it is easy to make a relative case for equities as an asset class rather than them looking particularly cheap in absolute terms.”
He added that there is a risk that investors have forgotten how unusual this period since the financial crisis in 2008 has been.
“You’ve typically had good returns from equities and bonds and, even better, the returns haven’t been particularly correlated,” he said.
Performance of indices over 10yrs
Source: FE Analytics
Indeed, as the above chart shows, both the Barclays Global Aggregates and MSCI All Countries World index have risen over the past 10 years, albeit in different fashions.
Osborne also noted that an economic policy regime change, moving away from monetary policy and fiscal policy becoming more prominent, could also impact markets as economic growth continues to improve slowly.
The co-manager of the four crown-rated BlackRock UK Absolute Alpha fund said the recovery in the US appears to be “self-sustaining” while Europe – a key engine of growth that has not been firing for many years – has also seen improvements.
Additionally emerging market growth is relatively robust with some uncertainties over the growth trajectory of one of its largest components China.
“Overall, global growth actually has strengthened over the last six months and therefore that normalisation of monetary policy is likely to be an ongoing feature albeit tentatively deployed,” Osborne said.
Therefore he said that central banks are likely to raise rates slowly clearly signposting any changes to markets with fiscal policy increased.
“I think every central bank that you would speak to wants to normalise because at the very least it gives them firepower once again should economic conditions change,” the manager said.
“So I think this gentle trajectory of monetary policy normalisation is likely to be ongoing and we are seeing much more consistency in the belief that fiscal policy is going to have to play a greater role.
“Central bank ambition will be to move rates slowly and to very clearly signal how they’re going to change their policy.”
He said the Federal Reserve was the best example of how this will occur, but there remains the potential for central banks to raise rates at a quicker pace than expected if they begin to fear a recession could be coming.
“The worst situation for them is to have rates at zero, maximum QE (quantitative easing) and then a growth stall because what do you do?” Osborne said.
“The greatest risk to that scenario is that central banks find themselves behind the curve and have to move much more aggressively than they would like to. The most likely source of that is if underlying inflation accelerates to a level where they are uncomfortable with.
“I think the ambition of central banks is very clear but I think markets would certainly squeal if rates went up sharply.”
The final factor that could contribute to heightened volatility is the return of the value trade, which investors saw first-hand last year.
In the UK for instance, the IA UK All Companies sector underperformed the FTSE 100 which typically had a higher weighting to value stocks such as financials and basic materials.
Performance of sector vs benchmark in 2016
Source: FE Analytics
“The market last year was very heavily positioned in quality growth and therefore that rotation towards value was incredibly violent and incredibly painful,” he said.
“It’s one of the reasons I think the absolute return sector maybe suffered last year because people had these factor biases built into their portfolios that they either were aware of and thought were the correct way to be positioned or they weren’t aware of the size of some of these biases.”
Indeed, the IA Targeted Absolute Return sector saw just over a third of funds register a loss in 2016.
This risk has not gone away, Osborne said, but added that timing the value turnaround is very difficult.
Overall, he said that the “risks to the conditions that we have all enjoyed over the last 10-15 years just do appear heightened”.
“I’m certainly not brave enough to tell you the day at which you’ll see those concerns realised, but I do think it is an important time for clients to be perhaps reassessing how they allocate thinking not only about return but about risk,” he added.
Osborne runs the £320m BlackRock UK Absolute Alpha fund, which aims to achieve a positive absolute return for investors over a 12-month period.
“We see this fund as having a dual mandate to generate consistent absolute return in all market conditions at low levels of volatility and it is the combination of those things that is so important,” the manager said.
“It’s not necessarily about profit maximisation it is about profit optimisation – for every unit of risk how much return can you generate.”
The fund uses a short book to hedge some of its positions, focusing on pare trades and taking a long and short position in similar companies that the manager feels he can exploit strategic differences in.
But currently, referencing the heightened uncertainty in markets, he said the fund has an index future that is at one of the largest points it’s been over the last four years.
This is a short position against the market rather than individual stocks and while it allows for increased liquidity it does not allow him to generate alpha.
“Of course the positive attributes of the future are that it is very quick to change your position in the future – it is a hugely liquid instrument – it is a cheap instrument,” Osborne said.
“The bad thing is it doesn’t give you the opportunity to create alpha because it is the index so there is no way you can create alpha by shorting it – that’s absolutely for controlling beta.
“So one of our tasks this year is to backfill the index position with stock specific shorts because it is through doing that we are able to create alpha.”
Since 2007, the fund has only failed to generate a positive annual return during 2011 when the fund lost 6.07 per cent.
Performance of fund over 10yrs
Source: FE Analytics
The fund has returned 42.62 per cent over the last 10 years with volatility of 4.51 per cent. It has a clean ongoing charges figure of 0.92 per cent.