Janus Henderson: Lower volatility forever? Don’t bet on it

(Foto: John Fujiwara, Portfolio Manager)

Volatility continues to reside at perplexingly low levels. The Chicago Board Options Exchange (CBOE) Volatility Index – better known as the VIX – has traded in a band around 10 since mid-May of this year, which is well below its long-term average of roughly 19. Investors seem to assume that “lower for longer” or even “lower forever” is the new normal when it comes to volatility, and may be complacent about the potential risks surrounding this assumption.

However, it is questionable whether low volatility is indeed the “new normal”. Is this a permanent shift, or actually an unsustainable environment? Is easy money creating low realised volatility as investors buy the dips? What could be a catalyst for volatility to spike? An overvalued market? An exogenous shock? The removal of accommodative monetary policy? And, most importantly, what can investors do to help protect themselves from the potential ramifications of this “new normal” unwinding?

VIX: January 2007 to June 2017

Source: Thomson Reuters Datastream. 1 January 2007 to 30 June 2017 Selling volatility: a primer

Low volatility is perpetuated by stubbornly low global interest rates. More and more yield-hungry investors sell volatility (ie, selling options, VIX futures or variance swaps) as a way to earn sufficient yield. Being 'short' volatility can be seen as the ultimate carry trade, as investors capture the difference between implied volatility and the realised volatility of the market.

The non-options traders among us can understand selling an option as something similar to selling an insurance policy on the market. One of the most common trades is to sell a 'straddle'. In this scenario, the sellers of volatility can profit as long as volatility stays within a defined range or decreases. The 'insurance' aspect comes into play if volatility goes outside that range, in which case the buyer of the option would be paid. If, however, volatility stays within the range, the seller simply collects the carry (ie, a premium). Since realised volatility is currently at such a low level, the boundaries of these positions need to stay in a tight range in order to be profitable.  

Two sides of the same coin
Another way in which investors participate in the trend of selling volatility is by increasing the leverage in their portfolios (eg, by taking on more equity exposure) in order to increase a portfolio’s risk. This may be done for a variety of reasons, including the need to meet risk targets or to increase return. Within this dynamic, if risk in the market (ie, realised volatility) decreases, leverage must be increased in order to hit targets, which is what we believe we’re seeing playing out now. The other side of this dynamic, however, is more concerning: if the risk in markets increases, losses will be magnified due to high leverage. 

Is this the new normal? 
What is puzzling about the current environment is that as soon as there has been any uptick in volatility, rather than seeing a 'risk-off' reaction – which was typical in the past – more people are instead choosing to sell volatility. It appears investors are lured by the attractiveness of slightly higher premiums, rather than interpreting an uptick in volatility as a harbinger of risky situations. Events that previously caused a sustained elevation in the VIX have instead barely caused a momentary spike, if anything. 
While certain factors in the market are likely contributing to this dynamic (eg, systematic trading, a low-yield environment, central banks’ desire to suppress volatility), low volatility may not be the new normal. Indeed, the process of central banks normalising monetary policy by unwinding quantitative easing measures may lead to an unwinding of this dynamic. If they are successful and investors can once again generate yield in less risky ways than by selling volatility (eg, earn sufficient returns in cash-based securities), selling volatility may not continue to be as popular a trade. 

The potential impact
If volatility were to spike and remain elevated, I fear it would have a huge impact on the markets. Since the consequences of being caught on the wrong side of this trade are dire, caution may be the best approach to this dynamic. 

Herding into volatility trades may be akin to picking up pennies in front of a steamroller. While investors may be able to capture returns in the form of premiums in the short term, at current levels it may not be sufficient compensation for the asymmetric risk they have agreed to cover. This trade is starting to be – or perhaps already is – crowded at levels where the risk/reward prospect is not attractive. 

Given these risks, we think investors should be extremely conscious of how they are exposed to market volatility and systematic risk, and be aware of: 

• Correlations: shorting volatility has a high correlation to the equity market
• Leverage: only a small uptick in risk could cause “forced” selling
• Flexibility: having the capacity to go long and short to capture potential opportunities

These are the views of the manager at the time of writing and should not be construed as investment advice.

Glossary

CBOE Volatility Index®  or VIX® Index®: Shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500® Index options and is a widely used measure of market risk. The VIX Index methodology is the property of Chicago Board of Options Exchange, which is not affiliated with Janus Henderson.  Options (calls and puts) involve risks. Option trading can be speculative in nature and carries a substantial risk of loss.

Volatility management may result in underperformance during up markets, and may not mitigate losses as desired during down markets.
Any risk management process discussed includes an effort to monitor and manage risk which should not be confused with and does not imply low risk or the ability to control certain risk factors.

Correlation: How far the price movements of two variables match each other in their direction. If variables have a correlation of +1, then they move in the same direction. If they have a correlation of -1, they move in opposite directions. A figure near zero suggests a weak or non-existent relationship between the two variables.