With low volatility, some investors think this market environment is like a calm before the storm. This is a significant issue among investors to whom Bernstein speaks. What is causing these low Vix index levels? In a May 16 report quantitative strategy report, Bernstein’s Inigo Fraser-Jenkins and a team identify four potential issues, then make a global observation regarding an investing world put to sleep and weigh in on including a short volatility strategy in a portfolio.
Low VIX Index level is the hot topic of conversation
The benign volatility regime that has beset stock investors, with the CBOE VIX breaking into single digits amid a world surrounded by fundamental risk potential, has been the subject of much discussions and analysis recently.
With implied volatility levels at “unusually low” levels, it is has become a consistent worry of its own. In recent client meetings, low volatility is an issue that “provokes the most unease,” Fraser-Jenkins noted.
While many have found it odd that volatility is so low, the Bernstein report looks for causation to help explain the aberration for what they describe as an “endemic” lack of volatility.
Low VIX Index – Four potential causes
Is there some causation for the benign volatility or is it just “shocking complacency” on the part of investors?
After sifting through various causation points, Bernstein arrives at four possible explanations to explain the historical aberration: (1) genuinely benign macro, (2) complacency by investors, (3) central bank asset buying (4) investors being unusually short vol.
Taking a step back from only looking at the stock market, Bernstein realizes that volatility across the board has dropped. Implied volatility for stocks has dropped on a global basis along with volatility in commodity and currency markets as well. Investors across the globe are not making rash decisions that would send assets dramatically higher or lower.
Is this a complacent behavior? To draw this conclusion, Bernstein looks at the “unremarkable” spread between implied and realized volatility. Based on this, implied volatility is not hinting at any “egregious level of complacency,” but rather is “merely keeping up with ‘facts on the ground.’”
What about central bank asset buying around the globe, a common whipping boy for low volatility? This is a tricky point of analysis, the report notes, as the unconventional policy has only recently been deployed. Thus, Bernstein does not have enough data on quantitative easing “to make strong statements” about the influence central banks have had putting a damper on volatility.
With regards to investors being “unusually short volatility,” a strategy that Bernstein says “makes sense for some investors,” there are several questions to answer.
Answering the core question, “are investors unusually short vol,” is difficult because “many of the most important market participants that have such positions, such as banks” have built “such positions through a derivatives business” that is traded over the counter and where market data is not public. Bernstein notes there are methods to calculate the short volatility positions in exchange traded products, but the over these positions are likely to be “dwarfed” by the over the counter derivatives positions the banks hold.
“When short vol positions do build up, the degree of worry attached to them depends a lot on who is taking on the trade,” Bernstein noted, as “payoffs tend to be highly skewed with large asymmetric downside.”
Looking at the issues and the available data, Bernstein concludes that a benign macro environment has beset the world and is thus the most logical causation.
Bernstein thinks a price readjustment will occur with “global equities fully valued, margins in the US declining and a transition from monetary to fiscal policy underway,” low volatiltiy will rise from the dead at some point. If the market is surprised, that could be a sudden and irrational movement that could damage the economy. If it is a gradual rise, the impact might itself be benign.