Market Volatility ETF Portfolio 3Q 2018 Review

Author: Leo Chen, Ph.D., Post Date: September 21, 2018
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The US equity market has had a strong third quarter this year. Our quantitative strategy benefited from the market rebound in July and August and took profits off the table at the end of last month. We have been sitting in all cash and waiting for the next entry signal since we exited near the market top.

 

Cumberland Advisors - Quarterly Review - Market Volatility ETF
 

The S&P 500 large-cap index is up about 9.69% YTD (ex-div) and hasn’t significantly deviated from where the market was at the same time last year. These numbers are certainly making investors happy, since the 10-year Treasury is yielding only about 3% nowadays. Although 2017 and 2018 show some similarities in the overall numbers, the detailed paths are quite different. We may still remember the ultra-low-volatility regime in 2017. But after a correction in February and some large spikes in volatility in the first quarter of 2018, we haven’t seen many short-volatility trades floating around this year. Needlessly to say, it was painful for the “short-vol” funds just half a year ago.
However, the third quarter proved to be another contrarian case. Market volatility continued its downward trend, falling to a 11-handle (Figure 1 below) and showing signs of relief after the spiral jump back up in February. While the 50.85% drop in VIX since April helps to explain the market comeback so far, it may be a misleading signal with regard to the underlying market. With the heated tariff war and midterm election coming up, we caution our readers not to interpret the VIX too literally. As we learned in the first quarter, VIX can spring up drastically in no time.

Chart 1. VIX since April 1, 2018. Chart source: Yahoo! Finance
The spread between the S&P 500 and VIX (Figure 2 below) continues in the third quarter: VIX is down over 20% while the market is up over 6%. This trend may be a sign of rising complacency in the market, as this type of widening does not typically happen during summer swoons. Nevertheless, as we always remind our readers, although we decided to go to cash with our quantitative strategy, that is not a short call from our model. Of course, “cash is king” has its merits. Our strategy is not to be afraid to hold cash and to be ready to enter when the time is right.

Chart 2. S&P 500 vs. VIX in 3Q 2018. Chart source: Yahoo! Finance
*Data updated on September 20th, 2018.
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
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