The unexpected recent surge in volatility has called into question how effective it is as a measure of risk for investors, according to M&G’s Eric Lonergan.
Recent sharp movements in the VIX – the so-called ‘fear index’ and a measure of near-term volatility as implied by S&P 500 option prices – have caused alarm amongst some investors.
Having enjoyed long period of low activity, the recent spikes have been caused by the market’s expectation of higher inflation and faster rate hikes than anticipated.
Lonergan, who co-manages the four FE Crown-rated M&G Episode Growth fund, said there have only been three other phases in the past 25 years when the S&P 500 index has moved so rapidly.
He explained: “Similar moves in the last 25 years have coincided with genuine events. The Asian crisis, the tech bust, and the global financial crisis. This latest ‘flash crash’ is distinct – it has occurred in the absence of news.”
Source: M&G
Indeed, Lonergan said when asked by clients about the “biggest bubble” in markets he usually highlights volatility and said the recent flash crash may indicate the size of the bubble.
“Every corner of the professional investment industry globally is obsessed with volatility,” he said.
“Risk managers base their processes around volatility, institutional investors want volatility targets, the private sector and the regulator are using volatility as the lens through which all is captured.”
He said volatility is easy to measure in an industry where “measurement is the holy grail” with volatility-based measurement frameworks omnipresent.
“Investors everywhere are being encouraged to define their ‘risk profile’,” he said. “This translates into constructing portfolios which attempt to target levels of volatility – the risk-averse elderly are encouraged to invest in less volatile funds, the risk-taking young professionals are encouraged to move higher up the volatility spectrum.”
However, the continued use of volatility poses three problems for investors and the industry, as Lonergan explains below.
“The first problem of which is typically unrecognised: investor behaviour is becoming correlated,” he said. “That’s jargon for saying more people are behaving in exactly the same way.”
“The correlation of beliefs and behaviour is one of the most compelling explanations as to why asset prices frequently move by far more than is warranted by changes in underlying fundamental news.”
Lonergan said if investors have different objectives, preferences and beliefs about the future, then there is a higher probability of orderly trade, with buyers easily able to find sellers.
“But if behaviour is correlated, and everyone attempts to move in one way it will require great price moves for the market to clear,” he said. “Correlated behaviour accentuates price moves.”
Performance of VIX over 1yr
Source: FE Analytics
Secondly, measurement and data have combined to create a “recipe for pseudo-science and over-confidence”, the fund manager said, with this effect greatly enhanced by the greater use of technology.
“Technology creates an incentive to quantify. That is the fundamental appeal of a statistical, price-based measure of risk,” Lonergan explained.
“We have vast quantities of data, we can compare all portfolios, and apply limitless computing power.”
He added: “Technology amplifies our hardwiring – we can copy and compare ourselves to everyone else.”
Lastly, Lonergan said volatility is not the same as risk as it only measures short-term fluctuations in value, arguing that the only true risk ultimately is the permanent loss of capital.
He said: “Volatility is a poor proxy, much of the time, for permanent loss of capital, and ergo a poor measure of risk.
“Certainly, measuring volatility using daily prices and three-month trailing sample periods – which underpins the famous VIX index - should be no one’s measure of risk, other than a leveraged VIX trader.”
The fund manager added: “Investors are not supposed to have daily time horizons, and three months is a spurious sample period for anyone with a three to five-year investment horizon.
“Most investors should be thinking at least in terms of five-year horizons, if not decades. Risk, fundamentally, is not a number – or at least not solely a number.”
Volatility’s “virus-like properties” have spread out to infect the entire industry, argued Lonergan, who is also a manager on M&G Episode Macro and M&G Global Target Return funds.
“It propagates because we can compare the volatility of diverse funds, we can measure it objectively, and – as is frequently pointed out to me – what is the alternative?,” he said.
The £977.9m M&G Episode Growth fund, which Lonergan manages alongside Jenny Rodgers and deputy manager Craig Moran, targets income and capital growth through investment in a range of assets and makes extensive use of derivatives.
The fund’s largest holding is in a FTSE 100 index ETF and also counts a number of M&G funds among its top 10 positions.
Last year the fund was a top quartile performer in the IA Mixed Investment 40-85% Shares sector delivering a return of 15.11 per cent compared with a gain of 9.98 per cent for the average peer.
Performance of fund vs sector since January 2011
Source: FE Analytics
Since January 2011, when Lonergan and Rogers took over the fund it has delivered a total return of 63.03 per cent, compared with a 54.63 per cent rise for the average sector fund.
The fund has an ongoing charges figure (OCF) of 0.94 per cent.