As we march through one all-time high after another in the third quarter this year, our quantitative market volatility strategy has benefited significantly from being fully invested. The leveraged portfolio has done particularly well.
The volatility index, VIX, which is highly correlated (negatively) with the equity market, made a remarkable all-time intra-day low of 8.84 and hovered around the 9-handle for quite some time before it came back to the double-digit level.
Undeniably, the US large-cap equity market is in a low-volatility environment. The “fear gauge” has ranged above a 15-handle only a handful times in 2017, and these temporary blips merely took it into the vicinity of its 5-year historical average. However, the lack of volatility is not necessarily allowing investors to sleep soundly at night. Many worry that the current market environment spells complacency. Nevertheless, if we take a look at VIX history and concurrent S&P 500 movement, we do not observe a pattern of stocks’ falling after VIX bottoms. In fact, if we compare one-year returns using a randomly selected date to one-year returns after the VIX drops to a 52-week low, we find no statistical significance between the two returns. This is because the VIX does not possess forecasting power, according to our research. (Please see our prior market commentary for details: http://cumber.com/goodharts-law/.)
If the VIX cannot predict equity returns, how does it help investors? First, even though the index itself does not confer forecasting prowess, it is still, by its mathematical design, a reflection of traders’ views regarding the coming 30 days. Like CNN’s Fear & Greed Index, VIX is a contemporaneous tool that gauges market sentiment. More importantly, the VIX can be a natural hedge, owing to its negative correlation with the market. Although trading VIX may not be suitable for every investor, financial innovations available nowadays provide many channels for sophisticated market participants to utilize advanced trading vehicles at relatively low cost. For example, while one cannot buy the VIX index itself, volatility ETFs and ETNs are available. However, the tracking errors of those products may be high due to the nature of the VIX.
Overall, we believe that even though idiosyncratic events such as North Korea’s missile launches may temporarily drive up the VIX, the low-volatility environment will likely persist through the rest of the year, barring major disruptions.