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It’s Not the Heat, It’s the (Lack of) Volatility: Searching for Alpha for July 2014

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The stock market has been absolutely ebullient this year. The major indexes cruised to new all-time highs more times than one can count in 2014, and with minimal volatility.  

The best way to measure how smooth the ride has been for investors is the Sharpe ratio. This metric divides the return less the risk-free rate by the standard deviation of a return stream. A large Sharpe ratio is indicative of a market that has delivered positive returns with relative small pullbacks. The result is the remarkable graph shown below. 

S&P 500 Rolling 24-Month Sharpe Ratio

What really strikes me is that, according to this measure, an investor has received nearly three units of return for every unit of risk. Even the most risk-managed strategies struggle to have a Sharpe ratio of 1. For an unmanaged equity index to be much above this number is really unusual. 

It’s likely that today’s low-vol, high-returning scenario will attract new money from those sidelined after the 2008 market rout. But a return to more normal volatility levels could quickly reverse those flows, creating even more volatility in the process. 

Investors should be well diversified, and avoid succumbing to the siren’s call of the equity markets.

Searching for Alpha June 2014


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