​Why is Volatility so Low and What Does it Mean for Investors

Why is Volatility so Low and What Does it Mean for Investors

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​Main Topic: Why is Volatility so Low and What Does it Mean for Investors

Why is Volatility so Low and What Does it Mean for Investors

I’m sure you have noticed by now that the stock market seems to have reached a point of very low volatility in daily changes at the index level.

Last week, the VIX, known as the volatility index or the “investor fear guage”, closed at one of the lowest levels in its 24 year history.

As a value investor, I view volatility as my friend, giving me the opportunity to buy something cheap.

But, as a student of investing, I like to understand what is happening in the markets from a mechanical and psychological perspective.

This episode is about volatility and what it really means.

The term volatility refers to the daily changes in stock prices. The higher the changes, the higher the volatility. For example, if stock indexes move a daily average of a quarter of a percent over a period of time, that is lower volatility than if the same index moves a daily average of one percent over the same period.

Most investors believe the VIX, the ticker symbol for the Chicago Board Options Exchange Volatility Index is an indicator of the level of volatility in the market overall. So let’s dive into the VIX to understand it’s structure.

Introduced in 1993, it was originally a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility.  By future, I mean 30 days.

To reiterate, the VIX is meant to show the market’s expectation of 30-day volatility.

The VIX is an index constructed using the implied volatilities of a wide range of S&P 500 index options. it uses the price of options on the S&P 500, and then estimates how volatile those options will be between the current date and the option's expiration date.

Options are priced based on three things: intrinsic value, time premium, and volatility premium.

Options have an intrinsic value based on the underlying stock price and the options strike price. The time premium collapses as the option gets closer to expiration. The implied volatility increases when the market is bearish, when investors believe that the asset’s price will decline over time, and decreases when the market is bullish, when investors believe that the price will rise over time.

Implied volatility is a way of estimating the future fluctuations of a security's worth based on certain predictive factors.

So the VIX is not predictive, it’s REACTIVE. As expectations change, the VIX changes to reflect this change in sentiment.

The higher the volatility of the underlying stock, theoretically, the higher the volatility premium built in to option prices, and therefore, the higher the VIX.

VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

The VIX itself can move dramatically in a day, sometimes going up or down 10% or 20% in a single day. It will tend to spike during periods where expectations of volatility

Since the VIX is an expectation of future volatility, not a measure of it, it has absolutely zero predictive power. We can’t use the VIX to determine whether or not the future is going to be volatile.

Can we bet on future volatility? The VIX is not an index that you can buy or short. There are, however, stock options that you can use where the underlying asset is the VIX index. But what are you really betting on using a VIX option? You are making a bet on how other people will feel about volatility over the next 30 days.

So back to our original question, why is volatility so low?

First, we’ll have to look at realized volatility which is computed using the standard deviation of returns over a prescribed horizon. Over the last twelve months realized volatility has average below eight percent, so the VIX right around ten percent does not look particularly low in context.

9-13-17-low-volatility-cotd

Second, there has been a tremendous amount of capital pouring into a strategy called “inverse volatility.” This strategy is essentially a bet on continued low volatility and there are hundreds of billions in hedge fund and institutional money in these strategies. These strategies may actually be a major problem for the market if all these players attempt to unwind these strategies at the same time – the elephants through the doorway problem.

Baupost Group, Seth Klarman’s hedge fund warned investors about this problem.

"While leverage is not directly responsible for every financial disaster, it usually can be found near the scene of the crime," Jim Mooney, Baupost's president and head of public investments, wrote in the letter. "The lower the volatility, the more risk investors are willing to or, in some cases, required to incur."

He added: "Structural leverage linked to low realized volatility may well prove destabilizing and the precipitant, or at least an accelerant for the next financial crisis."

These funds, including quant funds and so-called risk parity funds, target a specific level of risk, and when volatility spikes, sending risk upwards, it can trigger selling. That can then set off a cycle: volatility leads to selling, which leads to volatility, which leads to selling.

Third, volatility worldwide has been pretty calm. This phenomenon is not just local, but world-wide. The market continues shrugging off bad news worldwide, and this shows you how connected all the markets are.

Fourth, the economy has been pretty calm. Company’s earnings have been coming in strong, stock buybacks are continuing, unemployment is low, housing inventory is low (we need more), and so on.

Fifth, brokers are pointing to a record amount of client cash pouring into this climbing market. Now this is good reason for the slow but steady upward movement in the market, helping to create low volatility, but it is also a sign of a market getting close to the top: retail investors capitulate and start buying like crazy so they don’ t miss out on the continued rise.

Conclusion:

The VIX is low because of a congruence of effects from realized volatility being low, inverse volatility bets,  worldwide correlation, improving economies, and lots of money coming into the stock market. There may be other reasons, but these are pretty big ones.

​Ask JB: My thoughts on Schwab's Intelligent Portfolio service

Ask JB: Had a client ask me about Schwab’s Intelligent Portfolio service. He wanted to know my thoughts on it.

JB Says: Yes, I don't like ETFs, for a number of reasons..the fees they charge, the fact that the ETF price may fluctuate in a different direction than the underlying assets. The fact that ETFs are another Wall Street creation, etc.

Regarding the Schwab "intelligent portfolio" system:

Anytime you see anything that says "automatic re-balancing" I would be worried. The system can buy and sell as much it wants, generating commissions for Schwab. If they don't charge comissions, they are getting paid via the ETF.

Re-balancing means selling ETFs that are doing well and buying more ETF's that are not performing well? Not the best strategy for wealth creation.

Are all the ETF's Schwabs? You should understand the expense ratios of each.

Will Schwab charge any fees for this service, on top of the ETF expense ratios? Schwab Intelligent Portfolios charges no advisory fee. Schwab affiliates do earn revenue from the underlying assets in Schwab Intelligent Portfolios accounts. This revenue comes from managing Schwab ETFs™ and providing services relating to certain third party ETFs that can be selected for the portfolio, and from the cash feature on the accounts. Revenue may also be received from the market centers where ETF trade orders are routed for execution.

Will you get charged a load fee (sales fee) when the system buys into an ETF? How much? Some of these can be 5% of the buy-in.

I feel that buying two or three no-load index fund with the smallest expense ratio is a better way to go and then just sit on them.

It's also cheaper for Schwab to have you in this system. No face to face time necessary.

Ask JB: Hi JB,

I wonder what kind of books / material I should read to better understand the more multi-faceted industries such as retail.

For example, recently Kroger dropped a lot probably because of Amazon's acquisition of Whole foods and KR's announcement of cutting prices, which seems like a good value opportunity. But I am not sure that I understand sufficiently how the business operates, and hence am hesitant to invest.

Thanks in advance for any guidance.

Yaokai

JB Says: Start with reading the 10Ks of every company in that industry. Start with the best performing company and go from there. You’ll find yourself learning about the industry piece by piece. Then read recent presentations by each company so you can see what metrics they are focused on.

Do you have a burning question on investing you would like answered? Click the button below to send it to me and I will answer it on the podcast!

​Activist Investor Action Alert: Elliott Management Influences $ORIG

http://www.barrons.com/articles/elliott-associates-group-looks-for-change-at-ocean-rig-udw-1508553595

Thoughts on this podcast? Disagree with me on some point? Something I missed? Leave a comment!

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the “What Works In Investing?” podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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