Oh, how the world must have looked on May 16. The S&P 500 peaked its head above 2400, breaking into all-time highs, all the while geopolitical issues around the world didn’t seem to matter to investors as US market volatility, measured by the CBOE VIX index, played dead. To Man Group Chief Investment Officer Sandy Rattray, who co-invented the VIX index, it all seemed strange. In an interview in Goldman Sach’s “Top of Mind” publication released May 16, he predicted that it would end one day. Then on May 17 volatility spiked.

VIX

When someone says “it’s different this time,” make sure your wallet is secured

While some consider the historically low volatility market environment and say “it’s different this time.” As the VIX index dips its head below the 10 level amid numerous geopolitical concerns, high stock market valuations and a tepid economy swirling, there is talk that a new normal exists.

Rattray is clear and decisive on this issue. He questions “with conviction” the notion that a new normal exists and says one day this oddly flaccid market environment will wake up.

“The very low-volatility environment today will end at some point,” he said, responding to questions from Goldman’s Allison Nathan. While the market rally has been impressive, Rattray says stocks, particularly in the US, “don’t look terribly cheap today.”

As if to document the unusual market environment, Rattray points to volatility selling with surprise. “Historically there seems to be a new group of people each time that underappreciates the very significant risks of being short volatility and wants to learn this expensive lesson.”

That “expensive lesson” can occur during a volatility spike when an overleveraged portfolio learns how sharp the two-sided sword of volatility can become. The strategy is known for generating consistent and sometimes oversized returns regardless of minor market gyrations. On a correlation matrix, the strategy appears noncorrelated, until that faithful moment of crisis hits, then an improperly leveraged portfolio with insufficient risk controls can get wiped out – and using margin, a net worth can go negative.

While some in the derivatives space have dismissed short volatility as a viable strategy, Rattray notes that, in proper doses and with risk management, the strategy a place. “Shorting volatility should only comprise a relatively small part of a portfolio, and should have a clear risk-management process around it. If you don’t follow those two rules, then you could potentially end up in significant trouble,” he said. “There is no question that these short-vol strategies can pose significant risk to individual investors pursuing them if they are not managed appropriately.”

Man Group CIO Rattray addresses strategies that adjust leverage based on volatility

Looking at the world on Tuesday, before the latest Trump news broke the long calm in the market on Wednesday, Rattray said the volatility anomaly will correct at some point, it is just unclear when that point might occur.

A key concern Rattray, who at Man Group heads a firm that pioneered systematic investing strategies, speaks to risk parity strategies, although that phrase is not used in the entire interview.

“One concern is that many people choose to scale their positions by the level of realized volatility, which means there could be very large positions out there today with potentially significant leverage that might be vulnerable should volatility rise whether due to a tail risk event or other developments in the market,” raising an issue that analysts such as JPMorgan’s Marko Kolanovic and others have pointed out.

Stock market corrections and changing market cycles have been a fact of life since the beginning of free markets themselves. Rattray says investors need to have a plan to manage risk, not just focus on stock market reward.

“That plan could potentially involve a hedging strategy, a fund-management strategy, or it could come down to asset allocation or rebalancing—though rebalancing, of course, may exacerbate drawdowns,” he said, noting that “one side does not fit all.”