Equity market volatility has fallen across developed markets as the slow and steady global recovery grinds on, accompanied by ever-rising share prices.
A closely watched measure of the S&P 500’s volatility – the Chicago Board Options Exchange Volatility index, or Vix – is hovering around 12-month lows. But does that mean market risk is lower?
Volatility is the basis for most fund risk-rating tools and European regulators have stipulated that fund managers should use their volatility-based formula for the synthetic risk/reward indicators that feature on
investor disclosure documents.
But Morningstar Investment Management global chief investment off-icer Daniel Needham says the use of volatility as a proxy for risk is flawed.
“Volatility has been industry shorthand for risk for quite a long time and it has not done a very good job of predicting the risk that matters to investors, which is losses.”
Volatility is a poor judge of future losses and in fact periods of low volatility have preceded the past 10 great financial busts, he says.
Needham attributes this to the pro-cyclical nature of the financial world: bank lending becomes more prolific as asset markets rise, giving investors more equity to borrow more and in turn sending markets higher again.
The feedback loop can be devastating, especially as it throws a cloak of false security and reduced volatility on markets that quickly leads to panic when inflated asset prices begin to fall.
The bust that follows the boom – and the debt build-up underlying it – is the second-biggest risk facing investors, behind overpaying for
assets, the CIO argues.
“Right now, people think it is a safer environment because volatility is falling. But really, values are going up so it is getting riskier. Valuation is one of the most critical measures for looking at risk prospectively but it is also one of the least popular,” he says.
Buying companies at lower earnings multiples offered the best average return over the 23 years to 2013 and the average performance fell as the multiple increased, Needham’s research shows. Companies that were bought at high multiples also had higher cumulative drawdown.
Analysing volatility is useful but it cannot alone be the magic formula for predicting risk, Needham says.
“I do not think it is possible for it to be a purely quantitative exercise; it needs a judgement to be made,” he says.
He admits there is no ready successor to volatility as a measurement for risk, especially when investments need to be rolled out in a way that is cost-effective for the average investor. “The answer may not be easy or there may not be an answer,” says Needham. “We may need to accept that.”
Distribution Technology financial analytics director Chris Fleming says volatility is a commonly used statistic in analysing potential investments.
Volatility matches the credit hierarchy as well, as cash is the least risky and volatile, through to bonds and into equities, the most risky and volatile asset class.
Risk is an ambiguous concept and volatility only measures performance that deviates from the mean and captures both upside and down, Fleming says.
Volatility is used alongside historical performance, the outlook for interest rates, and other market information to determine the likely trajectory of investments as well as potential falls.
Fleming says a DT investment committee meets quarterly to make judgement calls on risk. But he says it can be dangerous for a firm trying to map out the relative long-term risks of different investments, which can drift into making “tactical” calls on asset prices.
“Six years ago, everyone said gilt yields were too low and could only go higher,” he says.
“Since then, they have gone even lower. It is really difficult to time exactly when volatility will hit the market.”
He believes this dynamic is “one of the key debates and misconceptions of our time.”
Kirrage says volatility is noise driven by emotional investors as businesses are, on the whole, relatively stable entities. At the very least, he says, more stable than their volatile share prices would suggest.
“To my mind, volatility is not a risk, it is an opportunity. An opportunity to buy and an opportunity to sell, but people obsess volatility about and it is illusory, it only exists in your mind.”
The loss is only crystalised when a stock is sold at a low point, he says. He adds that the one constant in macroeconomics is each decade will change the landscape dramatically.
He says: “On average, volatility does not stay in an equilibrium, like everything else in economics it tends to oscillate around.”
But Kirrage says problems can arise as investors crave certainty.
He says: “That is why Bernie Madoff a lot of money, because he could give you a straight line but unfortunately he was also a lying scumbag. The vast bulk of ways to mitigate risk were invented 200 years ago and there has not been too many additions since.”
Needham agrees, saying features such as risk ratings add to investor complacency.
“That feeling of certainty you get is actually false,” he explains. “Things like risk ratings are not going to help you make better decisions, they are going to make investors feel better about making those decisions which is incredibly dangerous.
“Investing is not roulette. It is poker where the players influence the outcome but you don’t know how many cards you are playing with, or if the decks are full.”