The only thing different about spikes in volatility this year might be the shorter time investors have to capitalize on them. Volatility has often risen sharply following unusually calm markets, but over the past decade the time in which the VIX reverts to normal levels after a spike has been shrinking.
Quicker mean reversions have implications for asset allocators: Diminishing windows to time market exits or re-entries mean advisors and consultants should put permanent structures in place to take advantage of volatility, rather than planning to respond after it occurs.
The perspectives on market volatility were shared by Harin de Silva, president of Analytic Investors, during a recent 361 Capital webinar, Today’s Investment Risk and Tomorrow’s Returns.
“In many ways, what we’re experiencing now is not unusual because lows of volatility are often followed by unexpected rises, and that’s part of what you get for investing in the stock market and the reason the equity risk premium exists,” de Silva said.
The chart below shows the VIX index’s tendency to spike after lows and puts recent market volatility in historical context.
“I don’t see recent volatility as a regime shift,” de Silva said. “It’s more a burst that’s typically associated with investing in equities.”
What’s changing about these spikes over the past decade is that volatility is reverting to normal levels at a faster pace. The second chart shows what de Silva refers to as the “half-life” of the VIX, or the time it takes for the VIX to mean revert. For example, if the VIX was at 10 and jumps to 20, the half-life would be the time it takes to come back to 15.
The VIX’s half-life has come down considerably since the financial crisis and now sits at an all-time low. One reason for the change is that the VIX is now traded more heavily, de Silva said.
Implications for Asset Allocation
A shrinking window before volatility normalizes makes it harder for most investors to be dynamic and capitalize on volatility as it happens.
“A few years ago, if you saw high levels of market swings, you could actually start selling call options and turning to some sort of short-vol position, knowing that volatility was going to decay away fairly slowly,” de Silva explains. “Now that happens much more rapidly, because professional investors are looking at spikes and stepping in and shorting.”
The change means advisors and other allocators should reconsider how they structure portfolios to benefit from volatility.
“If you want a portfolio that’s going to behave well in a volatility shock, you need to structure the portfolio in a way that anticipates the shock so you know what it’s going to do in that environment,” de Silva said.
“Incorporating a quality or low volatility factor tilt into the portfolio will benefit when there’s a volatility shock as opposed to trying to do something after the shock to help the portfolio,” de Silva said.
Read our last blog post, What is Alpha and Why Should You Care? >