The calm before the storm

Volatility has been low for a considerable time now but, as Emma Cusworth reports, plain-sailing investors could be thrown off course if they let complacency set in.

Volatility has been a constant headache for investors since the financial crisis, derided as much for its lows as its highs. In 2008, as the Vix began its staggering ascent from around 20 in July to over 80 in November, investors saw value wiped from their portfolios with equal speed. Volatility quickly became the catch-word for anyone trying to explain away poor performance. Yet, in the more recent past, volatility has been near or at record lows. Rather than rejoicing, however, experts warn of an eerie calm in anticipation of another jump in volatility.

DEAD CALM

For a considerable time now, volatility has remained low. Since Mario Draghi declared the European Central Bank would do whatever it takes to save the euro, average volatility has been below its long-term average. Between 27 July 2012, the day after Draghi’s speech, and 17 September 2014 the Vix has averaged 14.4, bouncing around between a low of 10.32 on 3 July 2014 and a high of 22.72 in December 2012.

Even geopolitical events have failed to send the Vix significantly above the 20 level considered to mark a period of high volatility. In February 2014, as violence escalated in Ukraine, the Vix peaked at 21.44. A week later it was back below 15, and remained around an average of 13.21 until 17 September.

“It’s like the quiet before the storm,” says Yoram Lustig, head of multi-asset investments UK at Axa Investment Managers. “It makes us nervous. The concerning thing about low volatility is that it usually comes before a big stress in the markets. It was at similar levels in the mid-90s and before the 2007 financial crisis.”

The Vix closed on 24 January 2007 at 9.89, only 0.58 above its record low of 9.31 recorded in December 2003. During the first six months of 2007, the Vix averaged only 13.16 before the collapse of two Bear Stearns hedge funds that July, which marked the start of the crisis. Volatility subsequently picked up, averaging 23.33 for the first six months of 2008, but once the full scale of the crisis became evident as Lehman Brothers collapsed, the Vix reached record highs of 89.53 on 24 October 2008.

A similar pattern occurred in the 1990s. Volatility averaged around 16.44 during 1996 and 19.92 for the first half of 1997 before the Asian financial crisis hit in July. Once the Russian crisis kicked off in 1998, leading to the collapse of the Long Term Capital Management hedge fund, volatility spiked with the Vix hitting a high of 49.53 on 8 August 1998.

 COMPLACENCY

One of the main problems with a sustained period of low volatility is that it promotes risk taking by investors. Recent months have seen a number of warnings from investment management houses against investor complacency. Brendan Walsh, multi-asset fund manager at Aviva Investors, calls this period of low volatility the ‘complacency period’.

“This is where implied volatility has reached a floor pulled down by low realised volatility. Investors tend to become complacent at this time and are put off hedging by the apparent high cost of protection, however this is exactly when they should be looking to hedge because spike or shock volatility is a very real risk. The Taper Tantrum is a prime example of this.”

Periods of low volatility present two problems for investors: firstly, yield becomes increasingly hard to come by and, secondly, many risk management systems get lulled into a trap of underestimating risk.

“People have been forced to increase the level of risk in their portfolios because of record low yields,” according to Ugo Lancioni, managing director and head of global currency at Neuberger Berman.

“Many risk systems look at the recent past and volatility has been exceptionally low over the last three to five years. The systems therefore calculate risk that looks low compared to five years ago. Investors seeing low numbers may be tempted to increase risk further.

The major disadvantage of these systems is that the future could look very different from the past. Investors are left with the challenge of assessing if we are about to enter into a regime of higher volatility.”

ALL EYES ON THE FED

The US Federal Reserve is the number one catalyst for higher volatility. Although tightening is recognised to be inevitable, when it will start and the pace at which rates will rise are critical factors in investors’ expectations, and therefore the path of future volatility.

Despite the Fed’s best efforts at being more transparent, confusion remains, which is evidenced by market prices out of line with the FOMC interest rate projections. Stewart Richardson, chief investment officer of RMG Wealth Management, pointed out in a mid-September note: “With the market derived curve for Fed funds some way below the FOMC’s projections, either the market is mispriced, or it simply does not believe the Fed’s economic and interest rate projections – possibly because the Fed has an awful track record in economic forecasting.”

As the Taper Tantrum of last summer proved, any language from the Fed suggesting a more hawkish stance than the market expects could send shock waves through markets. And if investors are holding more risk than they would be comfortable with under more normal volatility conditions, the reaction to a change in the Fed’s stance could dwarf the Taper Tantrum as investors rush to dump risk assets. “For investors fully loaded in low-quality credit, a period of higher volatility could clearly be a problem,” Lancioni states.