Our series on the Low Vix continues below- this was last updated on June 20th 2017 at 11:35AM EST
US equity market volatility remains near its lowest level in the last 50 years as the S&P 500 six-month realized volatility ranks in the 1st percentile since 1966 according to Goldman Sachs’ latest US Weekly Kickstart report.
The low volatility anomaly has persisted for longer than most Wall Street analysts dared to believe. That said, even though most analysts stopped short of claiming that market volatility will remain depressed for an extended period, as you can see below, predictions have been varied with some analysts saying volatility (as represented by the VIX Index) can drop further in the near-term while others were looking for a return to historical averages.
Goldman’s weekly report, speculates that the current implied volatility term structure “suggests that S&P 500 vol from one month through five years in the future will remain below its historical average” of 17.6 and 18.3 during the past 15 years.
In such a market the bank’s analysts are recommending a basket of high Sharpe ratio stocks as they believe these stocks offer a better alternative to the more commonly held realized volatility (min vol) ETFs, which have seen assets under management rise from $1 billion to $26 billion during the past five years.
According to the report, high forecast Sharpe ratio stocks have outperformed the S&P 500 on an absolute and risk-adjusted basis year-to-date. And this is where Goldman’s analysts believe most fund managers are making a glaring error. Instead of focusing on minimizing realized volatility the report argues, instead managers “should seek to maximise respective risk-adjusted returns.”
Focusing on lowering volatility at the expense of risk-adjusted returns may not be a desirable outcome the report speculates, as the cost of doing so may far outweigh the benefits. Indeed, a sector neutral basket of 50 stocks with the lowest 6-month realized volatility has trailed a basket of high Sharpe ratio stocks by a median of 84 basis points during rolling six month periods, or 170 basis points annually since 1999.
Professional volatility traders are likely the most aware of volatility dangers, known in slang as vol trap. It is understanding market crash risk in somewhat similar fashion to a pyromaniac who gets badly burnt but is still fascinated with the flame. Many volatility traders recognize the low hit rate for a significant volatility strike also carries a dramatically high average loss size. In other words, selling volatility naked without a proper understanding of the risks can lead to catastrophic failure. No one knows volatility dangers more than a volatility trader. It is for this reason that Deutsche Bank’s Aleksandar Kocic June 15 note on the “High risk of low volatility” is so striking.
Kocic on Low Vix dangers: don't follow the crowd, it is boring and could lead to tail risk
In many respects, New York-based Kocic epitomizes a classic noncorrelated thinker.
“Complacency has moral hazard inscribed into it,” he says, noting how not making a decision is, in fact, a decision. “It encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior.”
Joining the crowd is boring and, besides, the real action is behind the scenes.
Kocic didn’t go there, but he recognizes how following the consensus off a cliff ends with the worst possible consequence, tail risk materialized. He looks at the risk reward of trading volatility across the yield curve – a strategy for only the most adventuresome – and takes the same mathematical, unemotional approach to analysis.
Low Vix: falling asleep at the wheel leads to tail risk
This sedate market environment is a panacea, Kocic says, which has consequences. “Persistence of low volatility causes misallocation of capital,” he cautioned, calling it a “main danger.”
Volatility analysts including JPMorgan’s Marko Kolanovic have noted that when the volatility champagne cork is popped, there is actually an additional force of trend that will be generated by those short volatility covering their positions.
From one perspective, Kocic is echoing Kolanovic while at the same time discussing in a research report what is typically one of the most often discussed factors in derivatives risk management: risk controls on a short volatility strategy.
Both Kocic and Kolanovic are those unique thinkers who seem to relish in understanding the often macabre world of volatility: it is only interesting when a market crash occurs. Such thinkers enjoy taking apart a market crash, understanding its various technical and fundamental triggers, and then watch markets through this risk management lens. Kocic is in this group.
He notes that investors have increased their risk appetite as a global search for yield in the developed world has “compel(ed) investors to move across the frontier towards higher risk in order to enjoy the same return.”
Increasing risk in a low volatility world has consequences. Kocic puts this in a volatility trader’s language:
This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. Although volatility remains depressed, the risk is being pushed to the tails. And, as volatility could continues to decline, a buildup of tail risk is likely to become more acute, as probability of volatile unwind increases.
In other words, when free markets have been repressed with an artificial low volatility environment for a considerable period, the tail risk, once that market is unleashed, can be significant. Rather than try and sell volatility and collect dimes off the street, it is better to remain on the sidewalk so the oncoming bus doesn’t run the investor over. Hedge, Kocic advises.
“The prudent way of hedging that exposure is by finding a carry friendly tail risk hedges,” he wrote, making a trade recommendation, as “forward volatility fits exactly that description.”
Last updated on June 5, 2017 With the VIX trading at record lows and the S&P 500 pushing higher almost every day despite growing geopolitical and economic headwinds, you could be forgiven for thinking that complacency currently rules the markets. However, according to a report from Bank of America published last week, it is instability, not complacency that is currently dominating the Low Vix trading environment.
According to the bank’s research, prior to the May 17 1.8% S&P 500 drawdown, the realized volatility of the S&P 500 had been 5.7% (36 basis points daily vol). Therefore, while the decline was not large in nominal terms, it was, in fact, a five standard deviation event. There have been two other such events in the past 12 months. On September 9, 2016, and on 24 June following the Brexit vote. The frequency of these events mean that during the past 229 trading days, there have been three five standard deviation of events frequency of occurrence of 1.3%. In