Low volatility complacency

I GAVE a talk at an investment seminar recently which was titled "Investing Myths: De-bunking Widely Accepted Truisms".

Investment management is full of beliefs that at first glance seem to make perfect sense, and are often used as justification for investment decisions. The problem is that most of these beliefs are simply wrong, and result in investment recommendations that are based on wrong deductions. These recommendations usually end up losing money. A famous quote sums this up perfectly: "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

Last year, in my mid-year article we analysed how "Selling in May and Going Away" was a money-losing strategy. This time we tackle another money-losing idea that has been making the rounds as advice recently: the idea that a low Volatility Index (VIX) means that investors are complacent, and that an equity bear market like 2008 is just around the corner.

This conclusion is based on the single observation about the last time the VIX touched 10, in early 2007, which was soon followed by the Great Financial Crisis (GFC) of 2008. You do not need a degree in statistics to know that a sample of one hardly makes for a good observation on which to base any investment decision.

This 2007-2008 observation of the VIX, coupled with other crystal ball gazing remarks, such as we get a massive bear market every 10 years (1987 US stock market crash, 1997-98 Asian crisis, 2007-08 GFC), has caused many jittery investors to sell down equity holdings, or even worse buy the VIX ETF (exchange traded fund) to profit from an impending market crash. The fact that global equity valuations, especially in the US, are high lends further ammunition to the bears' argument.

Flawed thinking

Unfortunately bear markets do not follow such an arbitrary timetable. A closer look at the facts exposes the flawed thinking in concluding that a VIX of 10 is a trigger to sell equities. Since the VIX is the implied volatility of the S&P 500 index, all we need to do is look at how the S&P 500 performs when the VIX is low. The results may be surprising to all the speculators who believed that a low VIX implies complacency and too much investor bullishness.

Going back two decades, returns on the S&P 500 have been one per cent per annum higher when the VIX was below 21.50, compared to a VIX between 21.5 and 28.5. This means that low levels of VIX are better times to hold onto equities compared to moderate levels. The VIX is often below 21.50, a total of 62 per cent of the time, so the tendency is for volatility to fluctuate between 10 and 22 most of the time, and this does not mean that a market crash is imminent.

The last time the VIX was below 11 was in July 2014, and the S&P 500 has gained 32 per cent since then with no major crash in between, only small pullbacks that were quickly recovered. Selling equities just based on a low VIX is a mistake.

An even bigger error is buying the VIX ETF to profit from a low VIX. The term structure of implied volatility means that investors have to pay approximately 10 per cent every month in order to hold a long volatility position. Any investor who bought the VIX ETF during the last equity pullback in January-February 2016 has lost 86 per cent. Even if a repeat of the GFC were to happen tomorrow, it would not get this investor back to break-even.

It is true that valuations are high, the bull market is ageing and stock market leadership is narrowing. To top all this off there are significant concerns about the potential negative impact to the economy from the new US president and his policies, as well as his tweets. But equities climb a wall of worry, and this bull market is one of the most hated in history, probably because most investors are not participating in it due to all these perceived risks.

Interestingly, the above analysis of the S&P 500 and the VIX over the last two decades does lead to a profitable investment signal. Buying the S&P 500 when the VIX is above 28.50 leads to significant profits, as the market gains 42.6 per cent per annum when the VIX is elevated above this level.

The risk is that in the short term the VIX can zoom past 28.50 and go much higher, leading to losses in the short term. This, however, is a profitable and proven trading strategy that is far better than selling when the VIX is at 10.

A significant pullback in equities is always a risk and long-term investors need to accept the resulting volatility. Rather than trying to anticipate the next downturn and selling ahead of it, and running the risk of missing out on more upside, a better strategy is to use the VIX as a signal for when to add equities instead.

Many investing recommendations are made on wrong deductions that are easily exposed by analysing the facts. There are much better market indicators to use to gauge a market top and a low VIX is not one of them. W

AL Wealth Partners is an independent Singapore-based company providing fund management and advisory services to accredited investors