Record low levels of absolute volatility are at odds with the potential risks investors could face over the medium to long term, according to Psigma’s Tom Becket (pictured), who has warned against using it as a major risk measure.
The chief investment officer said 2017 has been an “extraordinary” year so far for asset class returns, despite significant geopolitical risks, threats of nuclear war, increasing global debt and a potential turning point for central banks to begin tapering policy.
Not only have asset prices risen significantly, according to Becket, they have done so with increasingly low levels of volatility.
“Any time you have even seen the smallest pullback in valuations or price levels there has been a rapid and rabid ‘buy the dip’ pattern,” he said. “’Don’t worry lads, the central bankers have got our backs; buy, buy, buy’ is the motto seemingly used across global asset markets.
“The behaviour that we have seen in markets this year ensures that the questions of ‘is volatility dead’ and/or ‘is it dead as a risk measure’ need to be answered.”
According to data from FE Analytics, the VIX (which shows the US market’s 30-day volatility expectations) is down 22.8 per cent year-to-date. Meanwhile, the MSCI World index is up by 11.43 per cent.
Performance of indices in 2017
Source: FE Analytics
While volatility – such as the behaviour of the VIX – is indeed one of the most commonly-used risk metrics among investors, Becket urged against using it in isolation, or indeed as a primary measurement of risk.
“I have to be totally clear that I think that I understand volatility but feel it is an inappropriate major risk measure, in that it tells you little about what might happen and is backward looking,” he explained. “These concerns I have are particularly pressing at this current time of the indiscriminate asset market party, elevated valuations and the lowest ever recordings in volatility in history.
“In investment practice, I am not sure that volatility can be anything other than an input into understanding the risk of an investment or your wider investment strategy.”
An example, according to the CIO, would be if an illiquid equity were to benefit from a strong run of performance and achieve steady, positive returns over a long period of time. While this would mean the volatility of the investment would be low, the illiquidity of the asset means it is higher risk and could be more susceptible to collapse.
“By all means, think about volatility but be aware of its limitations, particularly at a time when equity volatility is at the lowest it ever has been,” Becket added.
Not only this, the CIO said there are certain assets which he would deem to be high risk but are considered by many to be safe investments as they have low volatility.
“Some structured products, whose low-risk nature was highly questionable in 2008 and various vintages of European debt crises, are considered lowly volatile, simply because they don’t trade very often,” he explained.
“Likewise, the less frequent pricing of the underlying assets of UK commercial property funds leads to them being considered efficient from a volatility perspective, despite the fact that I would see them as the investment equivalent of ‘musical chairs’ as when you desperately want to get your money out (along with everyone else) you often can’t.”
In terms of making investment decisions for his clients, Becket said it is a case of focusing on appropriateness of position size, whether investments blend well together and whether valuations are excessive.
3yr rolling volatility of mixed asset portfolios
Source: Psigma
He also said it is important to be able to retrieve money quickly, easily and at a fair price if he decides to sell the position. This, according to the CIO, is why he mostly avoids having exposure to structured products or commercial property.
“To be clear, volatility can be your friend, not your enemy,” he continued. “Some of the best investment decisions we have made over the last fifteen years have been into investments that had recently demonstrated much higher volatility than they typically would, such as UK equities in late 2008 and Japanese equities in 2011.
“So, what about using volatility as a central guide to one’s portfolio risk and as a guide to future success or failure?”
Becket’s research below depicts several portfolios with different splits between UK equities and UK government bonds. Despite equity valuations rocketing to ever-new highs, the chart above shows that the portfolio holding solely UK equities has experienced the greatest fall in volatility.
“The limitations of volatility are clearly evident, particularly if you believe that current rates of volatility are unsustainable in the medium to longer term,” he said. “In effect, you could be coaxed into believing that a portfolio was lower risk, or indeed higher risk, than it actually was by simply observing volatility.
“In particular, we would argue that anyone adjudging equities or equity-heavy strategies to now be lower risk to be potentially reading the situation wrong.”
To mitigate these risks, Becket said it is important to maintain a genuinely multi-asset approach to investing for diversification purposes.
Given that almost all assets have performed so strongly over recent years, the CIO said certain market areas – in particular the likes of higher-risk credit and certain contrarian parts of global equity markets – have risen in volatility compared to most equities.
However, he reasoned that this is not a reason to be deterred from investing in these market areas and that, in recent conditions, investors should have embraced volatility and utilised a contrarian opportunity.
“We will continue to target inflation plus returns of various levels within certain asset allocation constraints for our clients over the long term,” Becket said.
“However, what would concern us is if our ‘upside capture’ of equity returns/increased correlation to equity volatility over the last two years was replicated to the downside when conditions in equity markets deteriorate, which is why we have progressively de-risked our strategies over the last year.
“If you want to be unnecessarily simple when thinking about volatility, what you want to do is have a high volatility relative to equity markets in bull markets and low volatility in bear markets, although clearly this is a difficult task to manage in practice.”
Overall, the CIO is unconvinced that volatility in asset markets is “dead” forever and that, while these periods can last for long periods of time, they will inevitably cease.
In today’s climate, he said there are enough headwinds to serve as a catalyst for higher volatility in the future and is therefore aiming to have a lower sensitivity to equity markets than he has had in the recent past.
“Our advice on using volatility as a guide to risk is to use it as part of your risk assessment, not the central guide, and to recognise the obvious deficiencies in currently using volatility as a risk measure,” Becket concluded.
“Is it ‘dead’ in its use? No, but we would suggest it is being discredited and is particularly dangerous at this point to use it as a guide to the future.”