Broker Check

Understanding Volatility and Its Impact on Your Portfolio

| April 02, 2018
Share |

Introduction

As much as volatility is discussed in financial headlines, few understand the potential impact volatility can have on a mixed portfolio of stocks and bonds, how it’s measured and why it’s closely monitored by market participants. Following an unprecedented year of historically low volatility and rising investor complacency, it’s important to understand how a return of volatility to historical norms can impact your investment portfolio. This paper hopes to accomplish just that, in addition to highlighting the ways in which Tompkins Financial Advisors mitigates portfolio risks associated with rising volatility.

History of the Volatility Index

Introduced in 1993 by Dr. Robert Whaley of Vanderbilt University, the volatility index, commonly referred to as the VIX, is best described as a barometer of fear and greed in the stock market. When stocks fall, fear rises in tandem with the VIX. When stocks rise, fear among investors falls in tandem with the VIX. Investors utilize this "fear gauge" to get a reading of investor sentiment, while traders utilize VIX futures and options to trade expected price swings in the stock market.

Under the hood, the VIX index measures the 30-day implied volatility that is being priced into S&P 500 index options. The constant rise and fall of S&P 500 option prices, due to increased levels of selling or buying, is the input that determines the price level of the VIX index.

Interpreting the VIX

The VIX is expressed as an annualized volatility measure, but it can also be used to help determine shorter-term market-price movements. If the VIX is quoted at 20, it can be interpreted as the pricing of a 20% annualized move in the S&P 500 in either direction, up or down, over the next 30 days.

A VIX value above 30 tends to indicate uncertainty in the market, heightened investor fear and volatile market swings. A VIX value below 20 tends to indicate quiet, less volatile markets with little fear and rising complacency among investors. 

Source: Chicago Board Options Exchange (CBOE). Goldman Sachs Global Investment Research.

Sharpe Ratio and Sortino Ratio

A common investment evaluation metric that is widely used by investors and also incorporates volatility, is the Sharpe ratio. This ratio measures the risk-adjusted return of an investment by dividing the investment return, minus the risk-free rate, by its standard deviation. The Sharpe ratio is an important metric to consider when comparing investments and helps determine if you are being adequately compensated for the amount of volatility you are taking on, but it also has its drawbacks. 

One caveat of the denominator in the Sharpe ratio equation is that all standard deviations are not created equal. While investors want nothing to do with downside deviation, they want everything to do with upside deviation. Unfortunately, the Sharpe ratio lumps together both downside and upside deviations, which can lead investors to favor an investment strategy that underperforms over time when compared to different investment strategies. An investment strategy that has a lower standard deviations, and thus a higher Sharpe ratio, would look more favorable than an investment strategy that has a higher standard deviation, and a lower Sharpe ratio. What if the investment strategy with the lower Sharpe ratio has higher volatility because it performs better on the upside? To prevent this from happening, investors should consider both the Sharpe and Sortino ratios when evaluating different investment opportunities.

The Sortino ratio, a variation of the Sharpe ratio, differentiates downside and upside deviation. The ratio is calculated by dividing the excess return over the risk-free rate by downside standard deviation. The ratio allows investors to evaluate an investment’s return for every unit of risk taken on. By rewarding investment strategies for upside deviation and penalizing investment strategies for downside deviation, Sortino ratio helps avoid the pitfalls of solely using the Sharpe ratio when evaluating two investment strategies.

Source: FuturesMag; Thomas Rollinger, Scott Hoffman

Rising Volatility, Rising Correlations

In order to better protect against market downturns, conventional investment theory holds that investors should build portfolios with a mix of stocks and bonds due to their historically low correlations to each other. Simply stated, correlation is a statistical measure of the tendency of the returns of one asset class to move in tandem with another asset class. A portfolio is considered well diversified when it is comprised of uncorrelated assets, the most popular choices being stocks and bonds. Historically, the correlation between the U.S. stock market and U.S. bond market has been 0.25.

As stocks sell off, an investor’s allocation to bonds should help reduce the portfolio’s volatility in exchange for lowered returns, as illustrated below in Exhibit 3. Over time, this relationship between stocks and bonds has proven to provide meaningful diversification benefits to investors.

Sources: Vanguard calculations, using data from Standard & Poor's, Dow Jones, MSCI, Citigroup and Barclays Capital. The calculations use quarterly return data; using monthly or annual return data would not change the relationships. Data covers the period January 1, 1926 through December 31, 2011.

However, during periods of broad market sell-offs, this aforementioned diversification benefit deteriorates as correlations between different asset classes begin to increase. During short windows of observation, historical correlations tend to meaningfully differ from actual correlations. This may leave investors with the false perception that their stocks and bonds mix serves as foolproof downside protection. Exhibit 4 illustrates the long-term correlation between different asset classes, while Exhibit 5 shows a short-term correlation between different asset classes increasing during a broad market sell-off. As is evident in the graphs below, the correlation of different asset classes can vary based on time horizon and the scope of the equity market sell-off in question.

Notes: US stocks are represented by the Dow Jones US Totalk Stock Market Index from 1988 through April 22, 2015, and the MSCI US Broad Market Index thereafter; US bonds are represented by the Barclays Capital US Aggregate Bond Index; international stocks are represented by the MSCI EAFE Index; emerging market stocks are represented by the MSCI Emerging Markets Index; REITs are represented by the FTSE NAREIT Index; commodities are repreented by the S&P GSCI Total Return Index from 1988 throught 1990 and the Dow JOnes UBS Commodities Index thereafter; high-yield bonds are represented by the Barclays Capital High Yield Bond Index; and international bonds are represented by the Citigroup World Global Bond Index ex US from 1988 throught 1989 and the Barclays Capital Global Aggregate ex US Bond Index thereafter. 

Sources: Vanguard calculations, using data provided by Thomson Reuters Datastream.

Notes: A similar spike in correlations was observed in 1998, a period characterized by the Asian Contagion, the Russian debt default and the collapse of Long-Term Capital Management. See Figure 3 for benchmark descriptions.

Sources: Vanguard calculations, using data provided by Thomson Reuters Datastream.

The reason for increased correlations between different asset classes during periods of heightened market stress is because during a flight to quality, the increased systematic risk outweighs the asset-specific risk and risky assets tend to suddenly become more positively correlated, often in contrast with how they perform during “normal” times.

After 2017, Likely Return of Volatility

The market environment in 2017 was not normal. Volatility was abnormally subdued while risk appetite among investors soared to all-time highs. The S&P 500 broke records, including going more than 33 consecutive sessions without a 0.5% daily decline, going more than 244 consecutive sessions without a 3% drawdown and going more than 400 consecutive sessions without a 5% drawdown. While 2017 was a Goldilocks year of strong returns and record-setting low volatility, investors need to realize that 2017 was an outlier and should prepare for a return of volatility to historical norms.

The historical average for the VIX since it was introduced is 19, and only 1.7% of the time since the VIX was introduced has it been below the 11 level. Historically, after prolonged periods of low volatility, a spike in the VIX has led to a more average VIX regime, as illustrated in the chart below.

Source: Goldman Sachs Global Investment Research.

Investors need to prepare for a return of volatility after a quiet 2017. At Tompkins Financial Advisors, a diversified portfolio to protect against market volatility not only includes stocks and bonds but also includes alternative strategies that have low correlations to equities and fixed income. While bonds don’t offer fool proof protection due to their rising correlations during periods of market stress, alternative strategies can offer another avenue of portfolio diversification. Of the alternative strategies utilized by Tompkins Financial Advisors, one is an option collar strategy. Option collar strategies hold put options on the market, which allow them to benefit from a volatile market and limit downside performance in periods of market stress, while also holding call options and equity positions, which allows the strategy to participate during periods of upside market performance. While the put options act as insurance and can slightly drag down performance during up markets, they provide crucial protection during sudden and sustained market drawdowns.

Conclusion

Volatility in markets is a natural function of the emotions injected into buying and selling securities by investors. As markets rise, investor fear subsides and volatility is subdued. A drop in markets increases panic selling among fearful investors and sees volatility increase. Investors can mitigate risks associated with market volatility by investing in a diversified portfolio consisting of equities, bonds and alternatives. Following a low volatility market environment in 2017, investors should prepare for a return of volatility in 2018. At Tompkins Financial Advisors, we are continually evaluating market volatility and strategically utilize alternative investments to help mitigate potential downside volatility while still capturing upside potential in the markets.

If you would like to receive a full-version of this white paper, please email us.

Important disclosures

Investments are not insured by the FDIC, not deposits of, obligations of, or guaranteed by the bank or its affiliates, and are subject to investment risk including possible loss of principal.

Bibliography

1. Phillips, Walker and Kinniry. “Dynamic Correlations: The implications for portfolio construction.” Vanguard Research (April 2012).
2. Rollinger and Hoffman. “Sortino ratio: A better measure of risk.” FuturesMag (February 2013).
3. Goldman Sachs Global Investment Research
4. Russell Rhoads. “Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes.” John Wiley & Sons (2007).

 

 

 

 

 

Share |