VIX Vexation and Why You Should Prepare for “Normal”

Much ink has been spilt of late ruminating on the cause of the low volatility environment in which we find ourselves. Indeed, on May 8th the VIX closed at its lowest level since December of 1993. Curious to be sure, given the laundry list of geopolitical and market related concerns facing investors. And while searching for the cause could be instructive, the fact is that volatility will not remain at these levels and investors need to prepare for a return to something resembling normality at some point in the not too distant future.

The longest period of time that the VIX has remained below its long term average was 539 trading days, and that streak ended on June 9, 2006, when, as reported by CNN, ” Ben Bernanke isn’t just scaring U.S. investors anymore. He’s scaring investors around the world. The recent stock market sell-off accelerated Thursday as investors from Jakarta to Bombay, and from Tokyo to Frankfurt to Wall Street, headed for the exits. The worry? That the Federal Reserve, and other central banks, might stall economic growth around the world in their bid to quell inflation.” Hmm, that doesn’t sound all that different from what the Fed is trying to achieve at present, but I’m sure they’ve gotten better at it, right?

Regardless, the current streak of days below normal for the VIX stands at a mere 132 days, far below the record reached in 2006, so clearly this could persist for a while. But if investing is a forward looking exercise, then investors need to be thinking about how portfolios will perform when volatility does normalize (and when that occurs, it will likely blow through “average” if history is any guide).

The table below helps to answer the question of how investors should prepare. It shows the correlations between the monthly change in the VIX and the monthly returns of 59 different asset class and strategy indices from February 1990 through March 2017. Not surprisingly, the only asset class that has a positive correlation with the VIX is Treasuries, and the only strategies that exhibit positive correlations with the VIX are Dedicated Short Bias portfolios and Managed Futures strategies. To be fair, that positive correlation between VIX and Managed Futures is modest, but at least the sign is right. So given the pain of hanging on to Short Biased strategies during equity bull markets, and the lack of return potential for Treasuries given the current level of interest rates, investors who understandably might be less than enthusiastic with Managed Futures allocations currently would be wise to stay the course.

Correlation with VIX

Read our related blog, Crisis Alpha?