Max Pacella
Investment Analyst
Macro & Markets
8 Jun, 2021

To expect a market pullback is to expect volatility.

By its nature, volatility is inherent in a free market, particularly one as liquid and active as the equity market – prices are marked every second and millions of individual decisions along with it.

Particularly since last year’s market collapse, volatility has been a focal point for investors, either an object of fear or a subject of delight depending on if you are long markets.

Given the evolving discussion around if markets are “toppy”, and addressing the perhaps not unreasonable concern that we are due for an equity market pull-back, it is an opportune time to examine the concept of volatility a little deeper and its true impact upon a portfolio.

A Definition of “Vol”

Volatility measures the distribution of returns in a particular index, stock, bond or any security generally.

What that actually means is that volatility shows how much the mark-to-market value moves, either up or down, in comparison to a reference price – generally this is either the mean price or a moving average.

There are generally two ways to calculate volatility, using either variance (a measurement of how far one data point is away from the average) or standard deviation (measurement of how spread out the data points are from the mean) – standard deviation is just the square root of variance, but most investors (including us) consider volatility to be the standard deviation of returns.

Source: Investopedia

Tracking Volatility

Investors around the world keep an eye on volatility as a means of adjusting or pricing in the risk of their portfolio, or to employ a strategy looking to benefit from increased volatility in the market.

How do they do this?

The most common index, which forms the base of many other volatility trackers, is the Cboe Volatility Index (VIX). Created by the Chicago Board Options Exchange (CBOE), this index is derived from the prices and volume of S&P 500 index options to create a 30-day projected volatility measurement.

The VIX is sometimes colloquially known as the “fear index”, with volatility supposedly being a quantifiable measure of market risk sentiment.

The NYU Tandon School of Engineering has a comprehensive paper on why the VIX is a fear gauge -but the cliff notes of their findings is that the market is generally assumed to be ‘long’ the S&P 500 and averse to risk, so if volatility rises then perceived risk is increased and the utility of a risk-averse investor falls.

Imagine this scenario for an investor in only a single stock, let’s use BHP as an example:

  • The investor is long BHP in their portfolio
  • They are uncomfortable with risk and only want BHP to move +/- 1% in a day to be within their level of comfort
  • Even if volatility increases to the upside, the investor perceives these movements as carrying risk, so they do not value the positive return as much as the potential downside
  • If BHP moves 4% in a day, the investor is fearful and is pricing in the risk more so than the increased potential return created by the move
  • This value that the investor places on owning and profiting from BHP is called “expected utility”

This scenario is a watered-down version of the VIX assumption, but highlights a point about risk-adjusted returns which we will touch on shortly.

It should also be noted that since the VIX is based off options contracts, the index inherently carries leverage – this means that abnormally high VIX levels generally indicated abnormally low levels of the S&P 500. Due to the nature of the underlying options used to calculate the index,it is not a linear relationship in price movements, and there is a skew towards negative movements in the S&P 500 causing a heightened VIX.

The chart below demonstrates the old adage, “markets go down in an elevator, and up in an escalator”, and the opposite is true for volatility:

Source: Bloomberg

You can see that for each sharp fall in the S&P 500 (blue), there is a corresponding spike in the VIX (yellow) – keep this in mind so next time you hear that the VIX is high, it does not necessarily mean that general volatility is high, but rather that the market has taken an aggressive fall.

How Does Volatility Impact a Portfolio?

Investing is a constant balancing act of risk and return – there is no investment without this trade-off.

Volatility tends to fall more towards the “risk” side of this trade-off, with an increase in market volatility forcing you to re-consider your risk-adjusted return profile for any security within that market.

Many models exist across different schools of economics to calculate the risk-adjusted return profile of an investment, with the Capital Asset Pricing Model (CAPM) being one of the most popular systems since the mid-1960s.

To consider how volatility changes the value, or “expected utility” of an investment, let’s consider a simple scenario with two assets in a very basic economy:

  • The ‘risk-free rate of return’ is 1.0% p.a. (a real-world example would be the U.S 10y yields)
  • ‘Market volatility’ is 1.0% p.a. (this is termed ‘beta’ in general investing)
  • Asset A:
    • Expected return of 3.0% p.a.
    • Expected volatility of 1.0% p.a.
    • An investor is happy to buy Asset A at this rate because the rate of return over the risk-free rate is commensurate to cover the volatility (i.e. risk)
  • Asset B:
    • Expected return of 10.0% p.a.
    • Expected volatility of 3.0% p.a.
    • An investor is happy to buy Asset B at this rate because the rate of return over the risk-free rate is commensurate to cover the volatility (i.e. risk)

In this scenario, both Assets offer an agreeable risk/return profile.

But what happens if market volatility increased by 5%, as might occur in a pull-back?

Asset A would be returning less than the expected volatility of the asset and market combined, so an investor would no longer be happy to purchase. In this case we shouldn’t assume that Asset A could go up in expected return, this is a pull-back after all.

So there is always a trade-off between what we expect an investment to return and its volatility, regardless of which direction we think that volatility is going.

Way back in our Guide to Performance Metrics note, we touched on the Sharpe and Sortino ratios, which measure the return of an asset relative to the amount of risk it takes over the risk-free rate of return – in this current market environment, Sortino in particular (as a measurement of downside risk) is incredibly important.

If you anticipate volatility from a pull-back, the actual utility of your current holdings and potential purchases changes fundamentally.

Protecting Against, or Benefitting From, Volatility

There are multitudes of ways that investors look to protect their portfolio from volatility, from holding cash to intricate option collar strategies.

Three potential means to guard against downside volatility include:

  1. Diversification of your portfolio
    i) This addresses the “market volatility”, or beta, of your portfolio by spreading risk across multiple asset classes, geographies, and risk profiles.
  2. Move to cash
    i) Though the least exciting option, moving to cash has long been a tool of investors to remove risk from the market in times of imminent volatility. This may sacrifice short-term returns from any remaining positive gains, but leaves an opportunity to purchase assets at a lower price once the pullback has occurred.
  3. Hedged strategies
    i) Without needing to learn options, strategies and funds exist in the market designed to hedge out long positions through leveraged short exposure.

    For example, the ProShares Short QQQ (SQQQ:NASDAQ) is a 3x leveraged ETF which looks to exactly replicate the three-times inverse performance of the NASDAQ over one day. If the NASDAQ 100 falls -1% in a day, this strategy supposedly will return +3%.

    Investors should be extremely careful with these strategies as they are both leveraged and have very specific recommended timeframes (SQQQ recommends only investing for no more than 24 hours). Given the leveraged nature of these securities, investments over the short-medium term can have significant implications and should only be used by those investors who understand the underlying financial instruments utilised.

    ii) Another example would be the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL), which targets bond yield volatility, something which is historically present during equity market pullbacks as well.

Volatile Materials

Volatility is necessarily a topic which investors should be wary about when it comes to the construction and management of their portfolio.

Although not a complete ‘doom and gloom’ scenario, it is important to understand how increased volatility fundamentally changes the return profile of a security, what this shows about market sentiment and how to position your portfolio in anticipation.

Markets move up and down all the time, but much like waves at a beach these movements can be tolerated if they do not catch the investor unprepared – if they do, you may be in for getting ‘dumped’.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.