Equity markets have been under pressure, with major US indexes down 4% to 7% in the second week of October alone, and market volatility has spiked. Depending on whom you talk to, the reasons for the sell-off and increased volatility vary. They include:
- Rising US rates. Ten-year Treasury yields have risen to over 3.2%.
- Increased trade tensions. There’s fear that the Trump administration’s posture toward China will eventually take a bite out of corporate profits.
- Technology stocks. Many have argued that a reversion to the mean for these high-flying stocks was long overdue, given their valuations.
It’s interesting to note that so far the sell-off in equities has not spread into risk aversion in other markets. Credit spreads, typically a leading indicator of broad-based stress, have widened but remain tight by historical standards. Further, currencies that would be expected to perform poorly in a risk-off environment—such as the Turkish lira and the South African rand—have been stable versus the US dollar. At this point all indications are that we’re not experiencing a panic-driven sell-off but rather a more orderly market pullback, which is to be expected in a more volatile market environment like the one we’re in today.
Is market volatility simply getting back to normal?
As we noted in an earlier blog post, the volatility we’ve witnessed in 2018 is something we should probably consider more normal. Think about the overall environment we’re in today: The Fed is transitioning from a historically accommodative monetary policy to a more restrictive posture. At the same time, equity valuations by any measure are fair to rich, but not cheap. Thus, the margin for error is less. Disappointing earnings announcements or economic data could create downward pressure on the market, which leads to volatility.
In fairness, US equity markets feel more volatile to investors because in 2018 we transitioned from the low-volatility environment we experienced in 2017. This transition to a higher-volatility environment has led to some very large one-day changes in the Cboe Volatility Index, also known as the VIX. In fact, Goldman Sachs reported that three of the top 25 one-day moves in the VIX since 1994 have occurred in 2018.1
Are stocks and bonds becoming too correlated?
Another concern for investors in this environment is the loss of diversification. As you can see in the chart below, the correlation between equities and bonds has been trending up in recent years as the Fed has begun to tighten rates and reduce its balance sheet. Large fiscal deficits, or an abundance of supply, are also putting upward pressure on rates. Overall, the increase in correlation reduces the diversification benefit investors receive from holding fixed income.
 Goldman Sachs, “Index Volatility: VIX Rationally Hits Post-Feb High After Several-Sigma SPX Selloff,” October 12, 2018.
Sources: S&P®, Bloomberg Barclays Treasury Index
The best response to market volatility
So where are investors to go if they’re concerned about the volatility in the equity markets and not inclined to put more money into fixed income? Is equity hedging the answer? Based on our research, hedging reduces expected returns. The only way investors can avoid this cost is by being incredibly successful at timing their hedge—not a likely scenario.
Another alternative for investors to consider is one that allows them to maintain some exposure to the equity market but in a defensive manner—one that seeks to capitalize on volatility by accessing the volatility risk premium. This objective is achievable in a liquid, transparent, non-levered format.
The bottom line
Equity market volatility is most likely here to stay. If this level of volatility is causing heartburn for an investor, it may be time to consider an alternative approach that achieves a similar long-term return objective as holding a fully invested equity portfolio—but with significantly less volatility.
> Concerned about market volatility? Find resources to help you smooth out the ride.
Potential Parametric Solution
We manage over $17 billion in investment strategies that seek to capture the volatility risk premium (VRP), a well-researched premium evidenced by the discrepancy between the volatility implied in equity index options and the equity index’s realized volatility. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA, Managing Director, Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Offices. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to the volatility risk premium. Prior to joining Parametric in 1994*, Tom spent two years working for the Federal Reserve in Washington, D.C. He earned a B.S. in Economics and an MBA in Finance from the University of Minnesota. He is a CFA charterholder and a member of the CFA Society of Minnesota.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.