There’s been no shortage of unsettling events playing out in many parts of the world. Yet, the popular barometer of market volatility and risk, “the VIX” (Chicago Board Options Exchange Volatility Index), has been at historic lows in 2014. With so much uncertainty still in the world, many investors are left wondering why volatility remains so low and how long it can last.

Three volatility investment experts from across Natixis Global Asset Management discuss the market forces behind this low volatility, if and when they see it ticking up and what strategies may potentially be used to help manage the effects of market volatility in portfolios.

 

Emmanuel Bourdeix
Head of Seeyond, Co-CIO

Natixis Asset Management
 

“Markets are by definition uncertain. However, everywhere we look we see that level of uncertainty increasing,” said Bourdeix. As a result, he believes volatility could spike up anytime now.

Bourdeix believes we are currently at a crux for asset allocators. In the U.S., if inflation picks up over the coming months, the Fed will be torn between keeping its accommodative stance and hence allowing equity markets to transition into bubbly waters or starting to hike rates. “We must not underestimate the lack of liquidity in certain segments of the fixed-income market, and even a minor interest rate hike by the Fed could be the trigger for a significant technical market movement,” said Bourdeix.

U.S. equities starting to look pricey
U.S. equities are beginning to look expensive to Bourdeix when he analyzes the CAPE Shiller index (Cyclically Adjusted Price to Earnings Ratio developed by Robert Shiller). “Should equity prices continue to rise at a faster pace than corporate earnings, they will start approaching the bubble zone, similar to the late 1990s configuration where volatility increased during the ‘euphoria’ phase of the bull market,” said Bourdeix. A similar situation occurred also at the very end of the 2003–2007 bull market.

Since 2009, investors have experienced a zero-rate environment, the lowest and longest on record, according to Bourdeix. Hence, the uncertainty regarding potential interest rate hikes is much higher compared to the last two rounds of rate hikes that took place in 1994 and 2004.

Bourdeix and his group have closely examined where the “real” interest rates have been lately versus where they should theoretically be according to SeeyondSM priority economic models. “The cut to zero was justified as theoretical rates were heading towards zero, and quantitative easing was warranted by the fact that theoretical rates were evolving below zero. Since then, theoretical rates have recovered and the trend is pretty clear: From now on, neither quantitative easing nor zero rates are justified, and the longer we stay in the current zero rate environment, the bigger the risk for the Fed to loosen its grip on monetary policy,” said Bourdeix. This is why he believes hawkish members of the Federal Market Operating Committee (FMOC) are currently pressuring Fed Chair Janet Yellen to speed up subsequent interest rate hikes.

Growing risks in Europe and Japan
On the contrary, in Europe, if growth remains disappointing, the economy may not be sufficiently resilient to absorb an increase in energy costs fueled by geopolitical tensions in the Middle East. Europe would therefore face a potential risk of deflation. In this anticipation, markets are likely to fall and volatility to rise. Besides, Japan is finding it more difficult than anticipated to overcome its recent value-added tax (VAT) rate hike and is clearly not out of the woods yet.

Performance of volatility investments has been lackluster for the past year or so, and some investors are questioning the utility function of a volatility investment within a global allocation. Bourdeix believes it is probably a good time to consider adding exposure to this asset class and be prepared to meet head-on the wall of challenges and uncertainty the global economy will have to climb in the coming months – especially as shifts in monetary policy from central banks play out.

Emmanuel Bourdeix is Co-CIO of Natixis Asset Management and Head of Seeyond Investment Division in Paris. He joined Natixis Asset Management in 2010. Prior to that, he was head of equity Europe, world and emerging countries at CAAM. He held numerous investment management positions at CAAM during his 12 years at the firm. Mr. Bourdeix began his career in 1995 at Dresdner Kleinwort Benson as arbitrage analyst and structurer. He holds an engineering degree from Ecole Nationale des Ponts et Chaussées and a DEA (post-graduate diploma) in probabilities and finance from Université Pierre et Marie Curie.

 

Harry Merriken, PhD
Chief Investment Strategist

Gateway Investment Advisers
 

According to Merriken, the low level of stock market volatility, as measured by the VIX, in 2014 has led investors to question whether volatility is permanently depressed due to market complacency or whether the VIX itself has become overtraded. Neither of these scenarios appears accurate to Merriken.

Fed QE behind depressed volatility
In fact, Merriken points out several reasons why the VIX is so low today, all of which reflect an interesting mix of market forces acting in concert. And behind all of it is the Fed’s quantitative easing (QE) program. “First, overall equity market volatility as measured by the VIX has moved in a narrow range. So although the range has drifted higher over time, the volatility index value has been well-contained. Second, call option prices rise along with volatility and interest rates. Therefore, in a period of depressed short-term interest rates, option prices – and implied volatility – are also depressed. That’s because, although options pricing takes into account many variables, an option’s value is heavily influenced by interest rates and volatility,” said Merriken.

Referring to the calculation of the VIX, Merriken explains that included in an option’s premium (the current price of any specific option contract) is a consensus estimate of volatility, often referred to as implied volatility. “Volatility must be implied because, unlike interest rates, the expected volatility over the life of an option cannot be observed. The VIX is computed on implied volatility over a range of shorter-term, near-the-money contracts,” said Merriken. As such, volatility estimates come from observing the trailing level of market volatility, or realized volatility.

Another key reason for low volatility today, Merriken believes, is that Fed liquidity tends to depress both interest rates and market volatility. “In the current market, liquidity abounds. As investors observe falling prices, they deploy excess cash into the market. Investors’ eagerness to deploy excess capital is one reason the market has failed to achieve a 10% correction over the last three years, despite several market declines,” said Merriken. However, as the market rallies off what many consider a false bottom, the lack of overall conviction in buying encourages early profit-taking. “As a result, prices peak well short of excessively extended levels. This tends to reduce the trading range of the market. The net effect is to depress the VIX,” said Merriken.

Lastly, while an increase in products and trading based on the VIX has allowed investors to take a view on market volatility, no evidence links the larger trading volume in VIX-related contracts with lower volatility. Therefore, he does not believe the VIX is overtraded and causing low volatility. But there is direct evidence that links equity trading volume with realized volatility, a root variable in determining the VIX, according to Merriken. This evidence, he believes, suggests Fed quantitative easing action is behind reduced market volatility and option premiums.

Stimulus exit expected to boost volatility
“Going forward, as the Fed removes monetary accommodation and interest rates ultimately increase, I expect that two separate, although not independent, factors will likely cause option prices and implied volatility (VIX) to increase – market volatility and rising interest rates,” says Merriken.

Dr. Harry Merriken is Chief Investment Strategist for the hedged equity firm Gateway Investment Advisers. He joined the firm in 1999 as a Senior Vice President. Prior to that, he was a principal at Alex. Brown Incorporated and worked in Private Client Investment Services, where he was responsible for the design and implementation of investment, hedging and diversification strategies. Previously, he was the Dean of Graduate Business Education at Loyola University Maryland in Baltimore and lead professor in the areas of capital markets and financial institutions. Dr. Merriken holds a PhD in finance from the University of Maryland. He received his MBA in finance and his BA in English literature from Loyola University Maryland.

 

Alexander Healy, PhD
Director of Strategic Research, Portfolio Manager

AlphaSimplex Group
 

Market volatility, as measured by the VIX, was certainly low for the first half of 2014. However, Healy believes investors should be taking broader measures of volatility than that.

For example, the volatility of volatility, or how quickly volatility can change over time, appears to have increased over the last decade. As a result, Healy believes investors should probably be more dynamic in how they construct their portfolios to account for rapidly changing market environments.

Healy adds that while the VIX is the most widely quoted measure of market volatility, it is important to keep in mind what the VIX actually is. “It is an estimate of the ‘implied volatility’ of the S&P 500® over the next 30 days, based upon the prices of S&P 500 options contracts,” said Healy. As such, it is a short-term, U.S.-centric measure and its level is driven by activity in options markets.

Simply stated, a low VIX reading means that the demand for options, or short-term insurance on the S&P 500, is currently low by historical standards. This makes perfect sense to Healy given that the companies in the S&P 500 have delivered consistent earnings and there is a very accommodative Federal Reserve in the U.S. that has made it clear that it does not expect to change its stance in the near future.

Above-average risk levels in emerging markets
Healy notes that a low VIX is also consistent with AlphaSimplex Group’s (ASG) own measure of risk, the Downside Risk Index (DRI),* which has averaged around 28 during the first half of 2014, well below its long-term average level of 55. However, ASG’s measure takes a broader scope and encompasses global markets. “By our measures, emerging markets have above-average risk, with Russia, Hungary and Chile (among other South American markets) exhibiting Downside Risk Index readings in the 60s and 70s, well above the U.S. reading of 28. So, while global uncertainty may not be reflected in the VIX, it appears to be reflected in some international markets,” said Healy.

In light of this, investors may be asking if U.S. volatility will increase anytime soon. While ASG does not attempt to predict volatility shifts or macro events, Healy points out that they have done extensive research analyzing market behavior. One such market behavior that is well documented is mean reversion – i.e., the tendency for asset prices to return to their historical averages over time. “We do expect measures of volatility, such as the VIX, to mean-revert over time. Specifically, given how low the VIX is currently relative to its historical average, we would expect an increase in volatility in the future. For us, it is not a question of if volatility will increase, it is a question of when,” said Healy.

Low-stress environment driving investor diversification
ASG’s research into market behavior also suggests that investors make poor decisions in times of stress because they are influenced by their emotions rather than rational planning. But what Healy is seeing today does not appear to be one of those environments. In fact, it appears to be just the opposite: a low-stress environment. “This is why I believe some investors are taking this opportunity to evaluate their portfolios and consider adding strategies with low correlation to stocks and bonds, such as trend-following strategies like managed futures,” said Healy.

Healy believes that if investors wait to diversify portfolios until there is a crisis, it may be too late. “Firstly, they will most likely miss out on the diversification benefits of a thoughtful allocation. Secondly, they run the risk that in a crisis their emotions will impair their ability to make the most rational decision, potentially making a bad situation even worse,” said Healy.

Overall, Healy believes markets are adaptive and volatility is not constant. For example, the VIX averaged less than 14 for the first half of 2014 and recently even dipped below 11. Contrasting this level with the financial crisis of 2008–2009, when the VIX hit 80, is just one of many examples of how volatility and market dynamics can vary over time.
 

*The Downside Risk Index is a proprietary index designed by AlphaSimplex to reflect the recent downside volatility of U.S. equity markets. Downside volatility is a measure of the extent to which recent volatility in the daily returns of a major index representing equity returns of a specific country or region has resulted from negative price moves (as opposed to volatility resulting from positive price moves). The DRI can range from 0 to 100, and higher values indicate that the recent level of downside volatility has been high relative to historically observed levels of downside volatility. The DRI is not a prediction of future returns or volatilities of U.S. equity markets, and investors should not rely on this index when making investment decisions.

 

Dr. Alexander Healy is a senior member of the research team at AlphaSimplex. In this role he conducts applied research and product engineering, with a focus on risk management, asset allocation, and non-parametric investment models. He is also a Co-Portfolio Manager on a few strategies. Dr. Healy joined AlphaSimplex in 2007, following the completion of his doctoral degree. While in his doctoral program, he conducted research for Microsoft and Google. Dr. Healy received an AB in mathematics and computer science from Harvard University, where he also earned a PhD in theoretical computer science. 

 

 


Bull market is a financial market of a group of securities in which prices are rising or are expected to rise.
 
Call option conveys the right, but not the obligation, to buy an asset at an agreed-upon price (“strike price”) within a specific time period. The buyer of a call option risks losing the amount paid for the option if the price of the asset does not exceed the strike price. The seller of a call option risks losing an amount equal to the asset’s price less the amount received from the sale of the call.
 
CAPE Shiller index is a valuation measure, generally applied to broad equity indexes, that uses real per-share earnings over a 10-year period. Popularized by Yale University professor Robert Shiller, this P/E ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle – therefore it is known as the Cyclically Adjusted P/E Ratio (CAPE).
 
Deflation is a decrease in the general  price level of goods and services.
 
Emerging markets refers to financial markets of developing countries that are usually small and have short operating histories. Emerging market securities may be subject to greater political, economic, environmental, credit and information risks than U.S. or other developed market securities.
 
Implied volatility is the estimated volatility of a security’s price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish.
 
Managed futures are futures positions entered into by professional money managers, known as commodity trading advisors, on behalf of investors. Managers invest in energy, agriculture and currency markets (among others) using futures contracts and determine their positions based on expected profit potential. A futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
 
Near-the-money contract is an options contract where the strike price is close to the current market price of the corresponding underlying security. An options contract is said to be near the money when the strike price and underlying security's price are close; it is at the money when the strike price is equal to the market price of the underlying security.
 
Option specifies the right to buy or sell a stock or other specified asset at an agreed-upon price within a specific time period.
 
Price to earnings (P/E) ratio reflects the relationship between a stock’s price and its earnings.
 
Realized volatility is also known as historic volatility and is the actual variance in the price of an option over time. Realized volatility is measured in terms of the standard deviation of the price from an average.
 
S&P 500 refers to a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors.
 
Tapering refers to winding down the U.S. government’s program of Quantitative Easing (QE) that has been in place since December 2008. QE involves the purchase of Treasury bonds and agency mortgage-backed securities by the central bank to help keep interest rates low.
 
Value-added tax is a type of consumption tax that is placed on a product whenever value is added at a stage of production and at final sale.
 
VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.
 
Volatility refers to the range of variation in market levels or individual security prices.
 
Non-diversified strategies can be used to provide diversification in an investor’s portfolio through focused asset class and market exposure. Diversification does not guarantee a profit or protect against loss.
 
Volatility investing/management techniques may result in periods of loss and underperformance, may limit the ability to participate in rising markets and may increase transaction costs.
 
This material is for information purposes only and should not be construed as investment advice. Any economic projections or forecasts contained herein reflect subjective judgments and assumptions, and unexpected events may occur. The statements and opinions expressed are those of the representative of the Natixis Global Asset Management subsidiary referenced. Opinions are subject to change at any time, and there can be no assurance that developments will transpire as forecasted. The opinions and information referenced are dated as indicated and cannot be relied upon as current thereafter.