Asset Allocator: August 2015- Assessing Market Volatility

In his latest asset allocator post, David Stevenson reviews the recent surge of volatility to view how spike in volatility and liquidity affect returns.

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: September 2015 

 

17/09/15- Assessing Market Volatility 

 

I’ve long felt that the old adage about the prevalence (or otherwise) of buses has huge relevance to the analysis of stock market volatility. The hugely over used adage of course is that whenever you seem to want a bus none appear and then suddenly three come along at once. I’m sure that some clever rocket scientist has used Gaussian analysis to analyse bus flows and deciphered this great mystery but stock market volatility certainly seems to conform to this rule. In essence we go long periods of time where markets are essentially quiet, with investors constantly terrified of some marauding black swans, and then suddenly out of nowhere we have not one but a cluster of volatility spikes! A copious literature of statistical analysis has emerged identifying why volatility spikes cluster in this way, but the evidence is overwhelming – don’t spook spooked investors unless you expect a savage market over reaction.

This fairly predictable pattern of behaviour not unnaturally scares the living daylights of many cautious investors. They’ve been taught not to watch the daily gyration of markets but they can’t help but be terrified of huge volatility spike spikes such as the recent scare about China. The chart below from Andrew Lapthorne’s quant team at Societe Generale shows one measure of market volatility – the VIX index which tracks the turbulence of the S&P 500 index.

This particular index is then viewed through the prism of 10 day changes over each September period since 1995. We normally expect September to be a bit more turbulent than normal but the most recent spike is hugely worrying. Lapthorne offers what I think is one very sensible explanation for why volatility has increased in this way involving hedge funds and quant driven investing. He observes the “tendency of many quantitative strategies to scale their positions using historical levels of volatility. CTA trend following systems will often scale price momentum signals by the underlying assets’ volatility (i.e. gross Sharpe ratio momentum) and risk parity and volatility targeted funds will hold positions proportionate to the historical volatility of each asset, hence the term, risk parity. This then leads to a degree of circularity. If volatility rises sharply, these types of strategies are then forced to reduce their positions, thus adding to the selling pressure and pushing up volatility further.”

Given this potential for market turbulence many investors sensibly react by dialling down their risk levels. This is usually achieved by putting money to work using various investment strategies that utilise stock selection criteria/screens to emphasise low volatility, defensive, quality assets. This approach sits at the heart of the smart beta revolution. In essence it’s an almost obvious portfolio play. Invest in risky stuff such as equities but exclude the more volatile assets in a systematic fashion. What’s even better is that this is possible within a low cost passive fund structure such as an ETF.

The $64 billion question though is whether this quantitative ETF based approach actually works. Do low volatility strategies actually cut down risk levels? One way of answering this is to look at how the stockmarket performed in its most recent sell off.

Step forward Andy Lapthorne and his quant team again at SG. In a paper from a few weeks back Andrew looked at the perfoemance of various smart beta strategies and examined how they  performed in the market sell off. His findings style based investors choosing strategies that emphasise quality stocks should be worried –these stocks don’t offer quite as much protection as we hoped. 

The chart below from the SG study very simply shows the big flashing warning sign – that quality strategies are becoming ever more closely correlated with riskier momentum based strategies. The chart looks at various regions over the last few decades, identifying the correlation between momentum and quality screens. As you’d expect this correlation varies over time (and between regions) but in recent months the correlation between quality and momentum has shot up across neatly all regions (bar Europe).

 

But there is also some good news from Lapthorne about the effectiveness of these quality strategies. Some of the strategies in August did “their job”, taking defensive positions whilst the typically higher beta value strategies underperformed. But there were some obvious exceptions notably the US “where counter to their below average market beta, low volatility strategies under performed a falling market when of course the purpose of such strategies is to do the exact opposite.” 

Digging deeper into the numbers Lapthorne discovers that “August also saw a significant rise in stock correlations which is not particularly unusual given the rise in overall volatility, one being a function of the other. But to see such a rise in the correlation of low volatility stocks above and beyond other correlations is somewhat strange. During August the median correlation within the low volatility rose to such an extent that it exceeded any previous readings [emphasis added]. The cause of this rise in volatility was in part driven by the increasing exposure of such strategies to what were lower volatility US stocks.” 

Lapthorne also discovers that “dispersion of investment style performance was also one of the lowest readings we have ever recorded during August, i.e. there was actually very little performance difference across the investment styles that we cover during the month. This then argues very strongly that the August sell-off was market driven and fairly indiscriminate, not economically driven, or a function of major style rotation”. 

This conclusion is, I would argue, hugely unsettling. My own sense is that we’re seeing three inter related developments. The first is that there’s a wider push for equity investors to dump risky, more volatile sectors and stocks and to favour calmer defensive options. As demand for this intensifies, liquidity is increasing in these stocks, pushing up valuations. This in turn is leading investors to be overly focused on the one market with deepest liquidity and the best range of quality stocks – the US. Add up all these factors and we see that quality, low vol is US centric, expensive (in terms of valuations) and liable to liquidity upsets.  If this analysis is right investors may not get the protection they think from these stocks in a big volatility spike i.e a massive sell off across the board/ The logical implication is that this pool of “disappointed” money (institutional capital annoyed that quality stocks are not offering the protection they wanted) will switch very quickly to high quality sovereign bonds pushing yields lower. 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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