Trends Watch: Volatility and Drivers

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.

This week, Elana talks with Dr. Euan Sinclair, Partner/CIO, Talton Capital Management.

What are the key drivers of volatility in today’s markets?

While for some years it can be difficult to think of any consequential news event, other years are dominated by one large story. Currently, we are seeing so many different news events: rising interest rates, a volatile earnings period, international trade disputes, BREXIT, the government shutdown, the inevitable dispute over the debt limit and the President’s legal issues. Investors must keep up with all these stories.

Several studies have shown that people can only process news slowly. When investors must process only one piece of information, a trend will form as the market adjusts. But when there are many pieces of information, the many overlapping trends will cancel out and we will just see higher volatility. And because the news events aren’t equally spaced in time, we will also see “higher volatility of volatility.” So volatility is currently being driven by a number of things. Each on their own might be uneventful, but the net effect is significant.

Are we in a high-volatility regime or a low-volatility regime?

Volatility might seem high but that is mainly because the previous few years have been so quiet. At the end of January, the VIX was 16.57. The median value since 1990 is 17.42. So, volatility is neither high nor low.

Why has volatility generally been lower than expected since the financial crisis?

That is a very interesting question, because the answer leads to an important point about volatility: Over long periods, the statistical features of volatility are remarkably stable. From 1990 to the end of 2007, the median VIX level was 17.7. Since then, the median has been 17. After a large event like the financial crisis, it is tempting to think that the markets have entered a new, higher volatility regime, but this has never been the case. The best estimate of the long-term future volatility is what it has been in the past.

Incidentally, the stability of volatility is one of the features that makes it far more predictable than returns. And this predictability makes volatility an appealing asset to trade.

Are institutional investors adequately hedged for a sustained upward surge in volatility?

I can’t comment on the hedging strategy of any particular company; there will be a wide range of exposures and risk tolerance. But, in aggregate, institutions are almost certainly under-hedged. Volatility risk can be hedged with index options or VIX futures and options. But all these instruments are expensive to carry and have negative statistical expectation. There is no cheap way to insure against a volatility surge. Investors will often choose to under-hedge rather than pay the premium for insurance.