As evident in the first chart above, the VIX (implied volatility) can remain low for extended periods of time. The VIX simply reflects expectation about risk in the future, and the price investors are willing to pay to hedge that risk. Therefore, a low level of implied volatility simply reflects extremely bullish investor expectations and indifference towards risk. Similarly, there is nothing to say realized volatility can’t continue to trend lower. Over the last few years, and certainly over the last several months, the equity market has shown a tendency to ignore negative news and rally nevertheless. In fact, during the 15% rise in the S&P 500 following the US election, the market shook off increased dysfunction and potential scandal in Washington, rising geopolitical tensions and terrorist activity, potential political upheaval in developed Europe, the prospect of continued tightening by the Fed, and a very weak 0.7% first quarter GDP growth number out of the US. Even May 2017 delivered lower volatility, even with a 46% one-day gain in the VIX, which was erased in a matter of days.
There are endless potential reasons for the market’s resilience over the last few years, including easy monetary policy by the Fed, ZIRP/NIRP from global central banks pushing investors into riskier assets including stocks, and fund flows dominating the market due to the growing force of passive investors. Perhaps these forces can continue to support the market indefinitely, leading investors into a glorious post-volatility world. However, with the Fed recently announcing plans to unwind its enormous bond portfolio, the “central bank put” could be in question. In addition, flows from passive vehicles could prove a double-edged sword for markets, meaningfully impactful on the way down as on the way up, particularly for funds with significantly mismatched liquidity.
Low volatility does present inherent risks to portfolio construction, particularly for certain types of strategies that use backward-looking volatility metrics for position sizing and risk management. A well-known version of this is a metric known as Value-at-Risk (VaR); VaR’s role in the 1998 LTCM downfall and 2007-2008 credit crisis has been widely covered. Essentially, these types of models rely on, among other things, trailing historical volatility to infer how much a portfolio can lose in a given period. With such a prolonged period of benign markets, these strategies are susceptible to volatility shocks, as complacent investor behavior causes an undervaluation of the real potential losses of the portfolio. The real risk in the portfolio is only realized ex-post, when the volatility environment changes and a market shock occurs. Particularly for strategies with leverage, this could potentially lead to a cascade effect, whereby increased volatility causes further selling pressure, further raising volatility, and so on.
To be clear, we are not forecasting another 2007-2009 scenario, but we are mindful of the dangers from persistently low volatility on investor behavior and portfolio risk modeling, even more so when leverage is added to the equation. Whether this is the calm before the storm remains to be seen; bubbles are always easiest spotted with the benefit of hindsight. However, at a time when valuations are sky-high by most metrics, margin debt remains near all-time highs, and geopolitical risk is rising, we view the historically low market volatility as a potential sign of apathy, not an all-clear signal.