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Where has the Volatility Gone?

March 7, 2005

 

With volatility at its lowest levels in 15 years, intelligent investors are asking two questions: 1: Where has it gone? and 2: What does it mean for me?

The answer to the first question has many professionals guessing, as volatility as measured by the VIX has steadily dried up over the past five years, losing over 50% of its value since 2002. The answer to the second question has also become a bit of a guessing game, as many have questioned not only HOW low volatility will affect different investments, but IF it will at all.

What is Volatility?

The first questions to ask are what is volatility, and how do we measure it? Investopedia.com tells us "volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time."

How do we measure volatility? Statistically, volatility is usually measured by taking the standard deviation of returns. Generally speaking, an annualized standard deviation of 10% would imply that approximately 2/3 of returns should be 10% higher or lower than the average return.

Investors and traders usually opt for different measures of volatility, however; the most popular of which is the Chicago Option Exchange's VIX indicator. The VIX is a measurement of sentiment on U.S. equities that the CBOE introduced in 1993. Derived from S&P 500 index options prices, the VIX is designed to reflect investors' consensus view of stock market volatility over the next 30 days. For the more technically inclined, the VIX represents the implied volatility of a hypothetical at-the-money OEX option.

Because investors buy protective puts in droves when the market is in a steep decline to protect from further declines in their portfolio's value, a high VIX reading usually represents increased investor fear and occurs during times of market turmoil. A low VIX reading implies everything is rosy, and investors are getting complacent in their need to buy protection against declines.

Where has it Gone?

There are many theories as to where the volatility (as measured by the VIX) has gone, but our favorite - and the most interesting - adorns the chart at the bottom of this article. The chart shows the precipitous decline in volatility since 2002 juxtaposed with the equally as rapid (but directionally opposite) move in hedge fund assets under management. If we hadn't run the numbers ourselves, I would swear someone had just turned the volatility graph upside down to show the rise in hedge fund assets under management.

The theory for how the growth in hedge fund assets and the decline in volatility are linked revolves around the strategies these hedge funds use. Several hedge fund strategies can be considered volatility draining, and the second chart at the bottom of this article shows the breakout of the sector weightings in the CSFB/Tremont Hedge Fund Index. This index is weighted by assets under management, and gives a good view of how assets are distributed amongst the various hedge fund classes.

You will see that the largest sector is Long/Short Equity, with approximately 26% of the nearly $1 Trillion in hedge fund assets, while Convertible Arbitrage, Equity Market Neutral, and Fixed Income Arbitrage have nearly 18% of assets when combined. These can all be classified as volatility draining styles, and we think it is no coincidence that they now command over 44%, or roughly $440 Billion is assets.

How are these styles volatility drainers? In the short space we have here, suffice it to say that each of the aforementioned volatility draining styles basically trade both sides of markets. Volatility is mainly driven by a lot of money flowing into markets one way or another, and then a lot of money flowing out of those markets; but when billions of dollars are pumping tons of money into one segment and removing tons form another - the net effect can be close to zero. In short - no ones making the big bets anymore. With huge sums of money flowing in from pension funds and institutional investors who demand strict risk controls and very low volatility in their investments, few funds are willing to "bet the ranch". Where have you gone Gerorge Soros?

Long/Short Equity hedge funds are basically just stock pickers who can both buy stocks and sell them short, leaving their net position usually very close to zero. Equity market neutral strategies are exactly that, and by design have no equity market directional exposure. And both convertible and fixed income arbitrage strategies revolve around buying one class of an asset and selling another class of the same asset simultaneously.

Imagine a 'pairs strategy' that a market neutral or long/short equity hedge fund would use in which they buy Fed Ex stock and sell UPS stock. They are betting that one company will appreciate relative to the other, but the net effect on the major stock indices and therefore the VIX, is restricting, as the buying in one is offset by the selling in the other. Further,. the fund will not buy puts to hedge their downside because it is hedged by having the opposite position in a closely related stock. Imagine this scenario across hundreds of thousands of pairs of stocks, bonds, convertible stock and bonds, sectors, and indices - and you start to see how these strategies can drain away volatility.

Another theory worth mentioning is that the decline in the VIX is simply mirroring a shift away form large stocks into smaller ones. The VIX only measures the implied volatility of the OEX, which is an index of the country's 100 largest stocks, and with the growth of smaller stocks far outpacing larger ones over the past two years; it is possible that investors are looking beyond OEX puts for protection, meaning less demand and therefore lower values.

What does it mean for Me?

The most common belief among investors is that low volatility is a bad thing for stocks, bonds, and markets in general as it means investors have grown complacent and any shock to the system will create knee jerk reactions which throw financial markets into turmoil. Turmoil in this case usually means a dramatic sell off. So in the general sense, the current low volatility could mean that we are in for a tough spot ahead. Of course, this has been the case for most of the past two years, and failed to come to fruition yet. .

For hedge fund investors, the lower volatility will probably mean lower returns moving forward. With the majority of funds selling volatility by doing market neutral investments, complex spreads and hedged trades (no pun intended); the spreads these funds are willing to accept will become smaller and smaller, and more and more money will go to each side of the market. The more funds that trade market neutral, the more neutral the market will become.

What the low volatility means to trading system investors is a bit different. The conventional wisdom holds that volatility is very important to day trading systems. The logic for this being a "good thing" for day trading systems such as Compass is that the more a market moves, the more opportunity there is to profit from such a move. If a system is long and the market rallies 8 points, that's $2,000 profit, but if a system is long and the market rallies 16 points, that twice as much profit.

But a new array of systems has emerged in the current low volatility environment which thrive on the tighter ranges and lack of follow through. Chief among these systems are Blue Wave Zones, Helix, and to a lesser extent the RC systems. Instead of waiting for a large single day move, such as Compass would, Blue Wave is content to trade several times a day. Because Compass will only trade once and in one direction, it can only achieve a portion of that day's range. Blue Wave Zones or Helix, in contrast, can trade several times per day - meaning they can possibly achieve several times the daily range. This is obviously beneficial in a lower volatility environment, but could mean drastically higher risk when and if volatility returns.

But don't hold your breath waiting for a big spike in volatility. Hedge fund assets continue to grow, and their unwillingness to "bet the ranch" will most likely continue, thus meaning continued low volatility.

- Jeff Eizenberg