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    The Death of Volatility?
     

    It’s been an extraordinary year. Not only have many asset class returns far outpaced the expectations of most commentators at the start of the year, but nearly every single global asset has joined (stayed at) the party. Whether its equities or bonds, vintage cars or decidedly average football players, the price of everything has boomed in 2017. Investors can surely rejoice at that.

    At the same time, despite the threats of nuclear war, political shenanigans, shifting central bank expectations, teetering global debt piles and question marks over the future economic potency of the world, there has been absolutely nothing to worry about, if you view volatility measures as an efficient guide. Indeed, each passing day seems to set new records in absolute levels of volatility and winning streaks of low/ no vol. Any time you have even seen the smallest pullback in valuations or price levels there has been a rapid and rabid “buy the dip” pattern. “Don’t worry lads, the central bankers have got our backs; buy, buy, buy” is the motto seemingly used across global asset markets. The behaviour that we have seen in markets this year ensure that the questions of is volatility “dead” and/ or is it “dead” as a risk measure need to be answered.

    We hear a lot about volatility, as it appears to be one of the risk measures that people think they understand. I have to be totally clear that I think that I understand volatility but feel it is an inappropriate major risk measure, in that it tells you little about what might happen and is backward looking. These concerns I have are particularly pressing at this current time of the indiscriminate asset market party, elevated valuations and the lowest ever recordings in volatility in history.

    In investment practice, I am not sure that volatility can be anything other than an input into understanding the risk of an investment or your wider investment strategy. Let’s start with specific investments. For example, say you have an illiquid equity that benefits from persistent buying and enjoys a gentle upward gain for a long time; the volatility of such an investment would be extremely low and thus perceived as low risk, despite the fact that it is potentially illiquid and when the news flow changes or investor perception weakens its share price could collapse. By all means, think about volatility but be aware of its limitations, particularly at a time when equity volatility is at the lowest it ever has been.

    In addition, certain assets that we would deem as “high risk” are considered to be lower risk as they have low volatility (most of the time). Some structured products, whose low-risk nature was highly questionable (I’m being kind) in 2008 and various vintages of European debt crises, are considered lowly volatile, simply because they don’t trade very often. Likewise the less frequent pricing (typically monthly) of the underlying assets of UK commercial property funds leads to them being considered efficient from a volatility perspective, despite the fact that I would see them as the investment equivalent of “musical chairs” as when you desperately want to get your money out (along with everyone else) you often can’t.

    So what are the major concerns that our Investment Team and I have when we make an investment on behalf of our clients? Firstly, what are the chances of losing money with this investment? If it is high risk and there is the potential that we could be early or wrong, is our position size appropriate and how will it blend with other investments in our portfolio? In addition, is this investment something that is well liked elsewhere, meaning that valuations are excessive? If we change our minds, can we get our money back quickly, easily and at a fair price (this is the reason we mostly eschew the dubious virtues of structured products and commercial property).

    To be clear, volatility can be your friend, not your enemy. Some of the best investment decisions we have made over the last fifteen years have been into investments that had recently demonstrated much higher volatility than they typically would, such as UK equities in late 2008 and Japanese equities in 2011.

    So what about using volatility as a central guide to one’s portfolio risk and as a guide to future success or failure? Perhaps the below adds some weight to the concerns we have. The chart shows various portfolios split between UK equities and UK government bonds (forgive my parochialism). It might well be that the results are not what you were expecting, but shows that despite equities smashing to new highs on a daily basis, volatility of equities or (in many people’s eyes) perceived “riskiness” is falling. To quote Tom Becket aged 13 ½, “that’s mental” (my vocabulary hasn’t improved in the last 26 years). The limitations of volatility are clearly evident in the below, particularly if you believe that current rates of volatility are unsustainable in the medium to longer term. In effect, you could be coaxed into believing that a portfolio was lower risk (or indeed higher risk) than it actually was by simply observing volatility. In particular, we would argue that anyone adjudging equities or equity heavy strategies to now be lower risk to be potentially reading the situation wrong.

    3 Year Volatility of Mixed Asset Portfolios.jpg

    So what do we do? As all readers will know, we pursue a genuinely multi asset approach, rather than a mostly equity filled strategy masquerading as a multi asset portfolio. Interestingly, because of the success of all assets over the last few years, but in particular higher risk credit, resources and certain contrarian parts of global equity markets (e.g. Japan), on some measures our volatility compared to equities has risen, although over longer periods it has remained pretty constant. Does the recent rise in relative volatility concern us? No, is the simple answer. Indeed, in recent conditions investors should have embraced volatility and ridden the recovery wave from the wonderful contrarian opportunity that presented itself in February 2016. Are we making structural changes to our investment philosophy or process? Absolutely not. We will continue to target inflation plus returns of various levels within certain asset allocation constraints for our clients over the long term. However, what would concern us is if our “upside capture” of equity returns/ increased correlation to equity volatility over the last two years was replicated to the downside when conditions in equity markets deteriorate, which is why we have progressively de-risked our strategies over the last year. If you want to be unnecessarily simple when thinking about volatility, what you want to do is have a high volatility relative to equity markets in bull markets and low volatility in bear markets, although clearly this is a difficult task to manage in practice.

    So back to my original questions. From a financial market perspective, I am totally unconvinced that volatility in asset markets is “dead” forever; periods such as we have just enjoyed can go on for a very long time, but ultimately they break. There are enough issues on the horizon to expect a higher volatility regime in the future and if that means losses in financial markets, we will aim to have a lower sensitivity to equity markets than we have had in the recent past. Our advice on using volatility as a guide to risk is to use it as part of your risk assessment, not the central guide, and to recognise the obvious deficiencies in currently using volatility as a risk measure. Is it “dead” in its use? No, but we would suggest it is being discredited and is particularly dangerous at this point to use it as a guide to the future.

    Tom Becket

    Chief Investment Officer

    Important Information

     

    ©2017 Investment Management. This article is prepared for general circulation and is intended to provide information only. It is not intended to be construed as a solicitation for the sale of any particular investment nor as investment advice and does not have regard to the specific investment objectives, financial situation, capacity for loss, and particular needs of any person to whom it is presented.

     

    The investments contained in this document may not be suitable for all investors. Prospective investors should consider carefully whether any of the investments contained in this publication are suitable for them in light of their circumstances and financial resources. If you are in any doubt whether any of the investments contained in this publication are suitable, you should speak to your Investment Director, or take appropriate advice from an accountant, lawyer or independent financial adviser authorised and regulated by the Financial Conduct Authority.


    The value of investments and the income from them can fall as well as rise. An investor may not get back the amount of money that he/she invests. Past performance is not a guide to future performance. Foreign currency denominated investments are subject to fluctuations in exchange rates that could have a positive or adverse effect on the value of, and income from, the investment. Investors should consult their professional advisers on the possible tax and other consequences of their holding any of the investments contained in this publication. This publication has been approved and issued by Psigma Investment Management Limited. Psigma Investment Management Limited is authorised and regulated by the Financial Conduct Authority with FCA firm reference number 478840.

     

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