What’s artificially driving volatility down?
Brian Singer, head of William Blair’s dynamic allocation strategies team and portfolio manager of the William Blair Macro Allocation Fund, posted a new commentary that looks at today’s low market volatility.
“Today’s market volatility is extremely low,” he writes. “In fact, over the past 50 years, there have been only two other periods — the mid ’60s and 1994 — where realized volatility for the S&P 500 was at or below current levels.”
The CBOE Volatility Index (VIX) has been below 10% for only 11 total days in the past 20 years — interestingly, seven of those days have occurred since mid-May 2017.
On Monday, the VIX fell below 11.
During sustained low periods of volatility in the past, Singer has repeatedly observed bad behavior by investors, such as increasing leverage and systematic market exposures.
“We certainly are seeing some indication of bad behavior by market participants, and we don’t want to be players in that same bad behavior,” he writes.
Singer believes there are several conditions that have driven volatility to artificially low levels.
A Changing Market Structure
The market structure has changed significantly, according to Singer.
Singer points to recent JPMorgan research that shows passive and quantitative investing accounts for about 60% of trading volume, which has more than doubled in the past 10 years.
In addition, only about 10% of trading volume is driven by fundamental, discretionary investors. According to Singer, “prices may significantly deviate from fundamental values, which can create opportunities for fundamental investors.”
In the current low interest rate environment, yield is scarce.
As a result of this scarce yield, Singer says that “investors are selling volatility to try to capture the premium between the implied volatility being priced into derivative contracts and expected realized volatility.”
The high volume of this trading strategy has dampened volatility, he adds.
Highly Leveraged, Systematic Investors
In an environment of low volatility combined with price momentum, there tend to be “highly leveraged, systematic investors” buying into the market as it moves up, Singer says. Singer sees this kind of activity happening today.
Singer says that risk parity is a good example of this type of “low-volatility, price momentum-oriented investing.”
“Since the global financial crisis, risk parity has benefited significantly from this development, but at this point, we believe it’s highly exposed,” Singer states.
Singer again points to JPMorgan research that estimates that these activities are driving volatility down by 4% to 8%.
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