Investors should not take market returns for granted as the CBOE volatility index – the VIX – hovers at low levels.
The VIX, often referred to as the Fear Index, is a measure of expected volatility on the S&P500 Index over the next 30 days. High VIX readings mean investors see significant risk that the market will move sharply, either up or down.
The VIX is hovering around the 12 mark (as at early September), and has ranged between 9.3 and 80.8 since its inception in 1990. This period could be the calm before the share market storm. In the past a low VIX has been a harbinger of significant market falls. The last time the VIX was at these low levels was at the start of 2007, the period immediately before the onset of the GFC.
Triple 3 expects volatility levels will start to climb higher by the end of 2014, with a lot of uncertainties ahead for world economies.
There is the potential for the housing bubble in China to deflate at some stage, the experimental quantitative easing taking place in Japan have unknown consequences for the Global economy, and the US’ decision to unwind its quantitative easing program which should see asset prices and risk premiums in that country return to more normal levels.
Throw into the mix the conflagration in Ukraine, the Middle East and a Euro-zone that is still grappling with policy solutions to address its maladies, and you have a number of potential potholes on the road ahead.
The backdrop against this is that equities are very fully priced. We have seen five years of a bull market where the S&P has gone from a low of 666 to sit at its current levels above 2000 and we are heading into what it traditionally the most volatile period of the year.
The bottom line is that investors can’t afford to be complacent about their portfolio diversification. Along with a mix of equities, bonds, cash, alternatives and property, investors can also diversify by investing in volatility itself.
Most investors see volatility as risk, but it is increasingly being recognised as a distinct asset class; one that offers a largely untapped source of portfolio returns that are largely uncorrelated to equities.
An investment in volatility can be accessed through the VIX with the use of options and volatility derivatives. It is a good natural diversifier.
VIX options have been one of the fastest growing option markets in recent years and now rank as one of the world’s most liquid – sometimes trading over 1 million options contracts per day.
Retail investors in Australia can access volatility through the Triple 3 Volatility Advantage Fund, which aims to generate long-term absolute returns with its volatility-focused strategy to capture alpha from highly liquid exchange-traded VIX options, which are negatively correlated to equities.
This type of investment strategy is expected to perform best in periods where the S&P is falling. In periods where the S&P is choppy, the investment strategy is expected to generate positive returns, and where the S&P remains stable or increases only steadily, the investment strategy is expected to generate cash-like returns.
Damien McIntyre is director and head of distribution with Grant Samuel Funds Management. The Triple3 Volatility Advantage Fund is distributed in the Australian market by Grant Samuel, and aims to generate long-term absolute returns, which are negatively correlated to equities.
