Janet Yellen seems to have a way of finding the right words at the right time. Just as talk of possible rate hikes in the US was starting to unnerve investors around the globe, the Fed chief was quick to soothe the markets with her remarks on keeping an overall easy stance.
Nonetheless, the financial world has entered unchartered waters in the past years, skewing markets and volatility alike. More precisely, the ongoing central bank interventions, a significant belief in quantitative easing and a lack of alternatives have significantly influenced asset flows, according to Georg Ruzicka, head of equity research at the LGT Bank (Switzerland).
“More than an estimated 80% of global equity market capitalisation is located in countries in which central banks have kept interest rates at virtually 0%, or where they have even slipped into negative territory,” he points out. A lot of funds have been rotating into equities, driving up indices, “with only very moderate and shallow pull-backs”.
Ruzicka concludes that “we are living in times of an unprecedented financial repression in which equity volatility has somewhat been contained”.
Indeed, widespread ‘fear-indicators’ of equity risk such as the VIX, which measures the implied volatility of S&P 500 index options, have been moving through a long trough ever since the last spike in 2011 (see chart below).
Back then, a possible Greek default had unleashed a market correction and provoked a sudden spike in volatility. But ever since ECB head Mario Draghi’s infamous promise to “do whatever it takes” to save the euro, things have clearly changed. Due to the lack of alternatives to equities, investors have possibly become somewhat complacent, according to Ruzicka.
“We are in a market environment in which investors blindly follow central bank promises, and may possibly over-estimate the power of central banks longer-term,” he warns. “It could make sense to partly hedge against setbacks.”
Demand from institutional investors for some form of protection against a possible return of volatility has selectively picked up. Ruzicka sees various hopeful strategies and refers to ETFs that track the VIX as one of several possibilities. These funds typically move in the opposite direction to the broader market indices and are therefore used primarily by investors who want to capitalise on volatility spikes following sharp market pullbacks.
However, timing is critical, as these instruments lose with every rollover during periods of stable volatility. Jeroen Vetter, an independent fund consultant from the Netherlands, says: “Volatility ETFs, which invest in volatility futures, are often being seen as a hedge tool when volatility spikes, but the opposite can be true. That is because of ‘contango’, whereby contracts further along the futures curve are more expensive than front month contracts.
“When volatility spikes, next months‘ contracts are more expensive than current ones, so this will evaporate the returns. I see an increasing number of asset allocators who are tactically trading, by either reducing or increasing their equity exposure as a way to avoid volatility.”
That in turn would not always lead to the desired result, since timing can works against them, which is precisely why some investors are opting for different insurance methods.
Matthias Hoppe, portfolio manager of multi-asset strategies at Franklin Templeton in Germany, points out that, while he is not expecting a serious market crash at this point, he has purchased some put options on the Eurostoxx 50 as well as on the S&P 500.
“Current low volatility levels offer a cheap opportunity to buy some portfolio insurance,” he says.Being a little on the safer side may not be such a bad idea at this point, according to Hoppe. “Equity valuations, although not at extremes, have reached a point where any bad news could provoke a market correction.”
Heiko Mayer, head of multi-asset income at Deutsche Asset & Wealth Management, notes that while volatility should not be underestimated, he views it as a mere side effect of current market events.
“Many clients typically focus more on maximum drawdown rather than on volatility,” he says. “Low volatility offers an opportunity to get a much cheaper protection in a client portfolio, for example through put options, which reduces potential drawdowns. Furthermore, in times of significantly rising volatility, these portfolios are usually less invested in risky assets reducing potential drawdowns as well.”
Easy does it
Alternatively, Joachim Klement, CIO at Wellershoff & Partners in Switzerland, applies a step-by-step approach in his strategy, by gradually increasing holdings in minimum variance funds. Unlike minimum volatility funds, in which only stocks with a defined maximum volatility level are chosen, minimum variance products focus on an absolute amount of volatility at a fund level. That means some individual stocks in the fund may actually have higher price swings than total fund volatility.
“However, we reached a maximum allocation to these strategies roughly a year ago,” says Klement. “It may have meant that we were a little early. But that is still better than being too late.”
However, it is important to differentiate amongst client groups, he notes. He sees particularly strong demand for these products from pension funds and insurance companies. “They need to rely on stable income flows, and therefore want to keep risk as low as possible to meet liabilities,” Klement concludes. Other clients such as family offices would typically take on more risk, “and are also more willing to sit through short-term turbulences as a trade-off for a possibly higher performance.”
The strategy of investing in these types of funds is not a new one. Allan Møller, head of fund selection for Danske Capital Product & Securites in Denmark, says: “We have had a European low-volatility
equity fund and a global low-volatility fund for several years on our platform. While we are currently witnessing an abnormal low volatility and rate environment, we are not worried that volatility will spike dramatically at this point.”
However, Møller does highlight that equity valuations are looking a bit stretched. “We are advising clients to take some risk off the table and to consider alternatives such as real estate or long/short funds within both equity and fixed income for example,” he says.
That is not to say that volatility may not spike at some point in the future, and Møller highlights an array of possible triggers such as an unexpected event on the geopolitical landscape or a worsening of the Greek debt situation.
“There may even be a negative credit event, if rates in the US really pick up, and we start to feel the full effects. That in turn could cause a market sell-off.” How far down the road a serious sell-off may actually lie, obviously remains to be seen – which is why it may not be such a bad time to start thinking about some form of protection against any return of volatility.