Many aspects of the market just don’t seem right to investment veterans – they’re not what they used to be. It is difficult to eke out alpha in stocks, while the beta on tap is tepid. Bonds offer scant yields – and the prospect of capital losses, should interest rates revert to historical levels.
Add to this a heightened level of volatility since the Lehman Brothers collapse. That was preceded by four years of relatively calm markets – just as the decade of the 2000s was preceded by nearly a decade of calm markets.
Call it a 30-VIX world. VIX is a measure of implied market volatility created by Vanderbilt University professor Robert Whaley in 1993. The measure is disseminated by the Chicago Board Options Exchange; there is now a futures market, and an evolving ETF market.
In today’s market, a VIX of 30 – the possibility of an 8% move up or down in the next month – is not remarkable, says Neil Simons, vice-president at Northwater Capital Management and chair of AIMA-Canada’s Education and Research Committee. He was the moderator at a recent AIMA-Canada discussion of strategies for investing in a 30-VIX world.
VIX shot as high as 80.9 during the market tumult of October 2008. A VIX of 30, Simons says, “is characterized as a high equity volatility environment.” But “it’s not extreme.” VIX over the past 20 years has averaged around 20.
So how do investors cope with higher volatility. At Horizons Exchange Traded Funds, president Howard Atkinson says “we like higher volatility.” With Horizons’ existing products, he finds that higher volatility boosts the trading volume of leveraged ETFs. Horizons is also planning to release a VIX product.
Leveraged ETFs – ones that cater to bull or bear views are also potentially part of a trading solution – but, he says, because they are rebalanced daily, they not only change the risk profile of the investment but the reward profile too, compared to traditional ETFs. Investors have to understand how the product works, and match their objectives with an expected hold period and expected volatility. The higher the volatility, the lower the expected return on a leveraged ETF — a phenomenon known as “volatility drag” – particularly in a low-return environment. Trending environments are favourable to leveraged ETFs; volatile ones are not.
Still, volatility can be traded directly on the options market, says Richard Croft, president of the Croft Financial Group. Assuming an efficient market, there are two ways to do it. One is covered-call writing, in which the stock holder “writes” an option, receiving a premium to protect against the downside, but running the risk of having the stock called should the price exceed the volatility band. He suggests that investing in two markets – one, the stock market, whose metric is return and the other, the options market, whose metric is risk – should produce alpha. Such a strategy would have produced a 9% return a year using the Montréal Exchange Covered Call Writers’ Index, as against 8% for the TSX 60 index, since 1993. But volatility was one-quarter that of the TSX 60. “I could be wrong here,” Croft says, “but I think that’s alpha.”
Still, there is a kink in the argument: options on indexes always overstate realized volatility, by between 1% and 2%, perhaps because retail investors can’t readily hedge. Contrariwise, they understate the historical volatility of individual stocks, perhaps because of the difficulty in estimating company-specific risk.
An alternative to trading volatility, suggests Chris Guthrie, president of CEO of Hillsdale Investment Management, is a “minimum risk” portfolio. “It’s not entirely a new concept,” he says, “but it has certainly become more useful and piggybacked on (Rob Arnott’s) fundamental indexing,” because it moves away from cap-weighted benchmarks.
The strategy involves sorting stocks on the TSX 60 according to their 120-day volatility – which Guthrie thinks is a reasonable forecast of volatility. Such an index won’t do as well on the way up as the TSX 60, but neither will it plunge as far. It keeps investors in the market, says Guthrie, and, like fundamental indexes, seems to reflect GDP better, with higher weights in utilities, telecoms and consumer stocks.
But it also has a tracking error of 9%. Still, it outperforms, without any hedging or shorting, “because all we’re doing is porting the returns from one period to another,” that is, lopping off the peaks and filling in the valleys. That slices the TSX 60 risk from 22.5% to 11.2%, with a better return, roughly 300 basis points according to simulated data.
A variant of this strategy has been developed by Nicolas Papageorgiou, an associate professor at Montréal’s HEC and director of quantitative research at Brockhouse Coopers. But in this instance, it’s not about lopping the peaks so much as recalibrating volatility to what was expected in the initial investment decision. That doesn’t mean avoiding risk – even tail risk – but trying to circumvent “fat” tail risk.
The problem, says Papageorgiou, is that “diversification works well when you don’t need it,” which is in a low volatility environment. “The higher the volatility,” he says, “ the less we want to allocate to risky assets.”
To accomplish this, investors have to recognize not only the level of risk, but also the fact that risk changes over time. The solution may be a futures overlay to smooth out volatility and make the fat tails leaner. That doesn’t affect the alpha component of the portfolio, but it dynamically manages the beta.
And, in what is becoming the mantra of the “new normal,” he argues, “you shouldn’t let the market dictate the level of risk in your portfolio.”