Volatility is Normalising: How to Navigate the Space
Volatility is a niche area and challenging to grasp due to its embedded complexity, yet the space has become a recurring topic of discussion ever since February 2018. On February 5, 2018, the VIX (real-time measurement of the market’s expectation of future volatility in the U.S. equity market) had its largest one-day move to date and surged just over 110% to 50. Subsequently, the XIV (inverse of the VIX) collapsed, and approximately $3.2 billion of short volatility positioning was wiped out, leading to roughly $2.6 trillion of losses in the S&P 500 ($1 trillion, of which, occurred on the same day the XIV imploded). The events of February 2018 were a reminder to us all that movements in this relatively small "asset class" of volatility can, indeed, affect broader markets.
U.S. equity volatility arguably remains somewhat low today. For context, let us note several periods in the evolution in volatility. Pre-2008 can be defined as a "normal" volatility environment, with some hedging demand from market participants, followed by periods of even higher hedging demands. Then, from 2012 to January 2018, we saw a relatively more muted volatility environment, even though realised volatility reached a floor during the summer of 2017 and experienced some sharp (albeit short-lived) volatility spikes.
As seasoned portfolio managers, we are well aware of the need to distinguish between the trading opportunity set and reality of markets. Thus, we are tactical in our allocation to volatility and have various tools at our disposal to capitalise in this space, broadly across four styles: tail risk, long volatility bias, relative value, and short volatility.
Tail risk hedging is usually theta consuming and difficult to time, and over the years, we have learned the hard way in this area and now generally avoid these strategies. Issues with shorting volatility are referenced above, and thus are exposures that we aim to stay away from even if some of our managers can (and do) employ temporary short biases.
Notwithstanding, we frequently implement relative value as (a core part of our portfolios) and, on an opportunistic basis, long volatility bias strategies. The former targets an uncorrelated, diversifying, all-weather return stream while the latter aims to generate positive returns with a negative beta. In particular, we like relative value managers due to their dynamic allocation across global asset classes and strategies.
As there are many different approaches to gain exposure to volatility, we will address one strategy where we see a growing opportunity set: dispersion. Dispersion seeks to take advantage of relative value differences in implied volatilities by shorting an index and going long a basket of the index’s constituent stocks. Due to demand for hedging, index options tend to trade at a higher implied-to-delivered volatility premium than single stock options. As a result, implied correlation also typically trades at a premium to delivered correlation.
Dispersion usually works well during times of market segmentation, temporary shifts in correlation between assets, and idiosyncratic news on individual stocks. Generally, the most supportive environments for dispersion are when volatility increases and remains elevated such as 1999, 2000, 2008, and Q4 2018. Regarding 2018 specifically, while volatility was higher than 2017, note that volatility in 2018 was still just below the 20 year VIX average (pre-2017 and excluding 2008) of approximately 18.
Given the collapse of the XIV in February 2018, U.S. equity markets may go back to a more "normal" volatility environment by historical standards. One could argue, for instance, that the XIV kept an artificial lid on U.S. equity volatility. Further, while volatility has generally been constrained by quantitative easing programmes, industry consensus points toward a continuation of the upward trend in volatility with the implicit put by central banks weakening.