The recent bout of volatility that began in February caught some market observers, and participants, by surprise. To many, it marked the return of risk.
Volatility, or standard deviation, is the most widely used proxy for risk in all of finance. It measures the dispersion of returns around the average for a given asset. An investment with lots of variability in returns from one period to the next has a high volatility; one with more stable and predictable returns has low volatility.
The Chicago Board Options Exchange Volatility Index, or VIX, is the most commonly cited benchmark for equity market volatility. While technically calculated via the implied volatility of S&P 500 options, it’s a reasonable representation of market volatility.
This February 5th, the VIX surged from the previous trading day’s close of 17.3 to 37.3. Not only was this the second-highest level of a VIX close since 2011, it represented the largest daily percentage increase in the three-decade history of the index, more than doubling in one day. This increase itself was nearly twice the next largest daily jump ever.
Exacerbating the effect of such a move is the fact that it follows one of the lowest-volatility environments ever recorded. Since its inception, the VIX has had a daily average value of 19.3. In 2017, it averaged a mere 11.1. In fact, of the 100 lowest VIX days since the turn of the millennium, 77 came in 2017!
Institutional investors haven't historically trafficked in volatility products. However, after the 2008 credit crisis, a proliferation of funds emerged touting long volatility exposures or tail risk hedging. Such products promised to make money when markets fell and volatility rose, but instead simply bled slow losses over time as the put options they bought expired worthless. One of the best decisions to do nothing I made as a consultant was to not recommend a single one of these products.
Witnessing this long-volatility strategy steadily lose money for a decade, an increasing number of market participants today have taken short volatility positions, either selling put options or outright shorting the VIX itself through various futures and exchange traded products. In fact, last year I attended a conference where institutional investors were being advised to sell puts as an equity replacement strategy, with the VIX at eleven! Unfortunately, as evidenced in February, when volatility is at lows, it has nowhere to go but up. And when volatility spikes, short volatility strategies blow up, as LJM Partners discovered.
Further, the proliferation of exchange-traded products on the VIX has allowed retail investors to join in the fun. A quick screen for “VIX ETFs” returns nearly 50 offerings with about $4 billion in assets tracking the VIX. More than half a dozen of these are short volatility.
Traders lucky enough to have purchased the VelocityShares VIX Short Volatility Hedged ETN (ticker symbol “XIVH”) on February 1st of this year paid nearly $74 for the fund, and by February 6th, it was worth $13.74 per share. Ouch.
For now at least, the fixation on volatility appears here to stay, but such myopia strikes me as odd. For long term investors — at least those who don’t short it — short-term volatility is all but meaningless.
If you really want to measure risk, you first have to start by describing what failure looks like. And in order to describe failure, you should begin by defining success.
For a long-term institutional investor — such as a pension, foundation, or endowment — success is meeting or exceeding your required rate of return. It’s not beating your peers, or even generating alpha. Whether it’s a fixed nominal rate of return, such as the 7 percent or 7.5 percent often assumed by pensions, or the target of inflation plus 5 percent commonly required by endowments, success is simply hitting your number. By logical extension then, failure means not achieving your required return. In this framework, risk is anything that could lead to failure.
Here the irrelevance of volatility becomes clear. For the sake of argument, let’s assume a pension can only select between two portfolios. Portfolio A generates a return of 2 percent, with a volatility of 1 percent. Portfolio B generates a return of 10 percent, but with an annualized volatility of 12 percent. Most investors will say that Portfolio B is far riskier.
But if an investor’s required rate of return is 7.75 percent, which return stream is riskier over a 20-year period? Portfolio A is guaranteed failure. At the end of the day, the only risk that truly matters is this risk of investment underperformance.
Volatility itself is not risk; it is noise. It is the interim discomfort we as investment professionals must absorb, withstand and manage to achieve the ultimate objective: generating the required rate of return over the investment horizon.
Volatility, like illiquidity, could more accurately be thought of as a lever. Theoretically, the correct amount of volatility you should prudently accept is the level that provides the highest cumulative probability of success.
On the other hand, volatility can create a risk: that we reduce our market exposure at the point of maximum psychological pain; in other words, we sell at the bottom. Such behavior is deleterious to long-term investment results. While it certainly feels good to proactively do something and alleviate the mental anguish of a portfolio drawdown, sometimes the best thing we can do is simply nothing.