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Why the Volatility Spike is the Low Volatility Strategy’s Best Friend

Do Active Funds in India Benefit from Higher Active Risk Exposure?

Implied Plunge Protection

2019 Mid-Year Persistence Scorecard - Key Highlights

Corn Pops to a New High

Why the Volatility Spike is the Low Volatility Strategy’s Best Friend

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Berlinda Liu

Former Director, Multi-Asset Indices

S&P Dow Jones Indices

The first half of 2019 saw one of the biggest rallies in the domestic market; the S&P 500® rose 18.54% on a total return basis despite concerns of slow economic growth, a trade war, and a possible rate hike. During the same period, the S&P 500 Low Volatility Index surprised the market and rose even more. The index outperformed the broad market by 99 bps in the first six months, and 90 bps in the second quarter.

The S&P 500 Low Volatility Index generally tends to outperform in down markets and underperform in up markets. However, the first half of 2019 reminds us that, as its name would suggest, the S&P 500 Low Volatility Index’s outperformance partly comes from its ability to reduce volatility drag. As a result, it may even beat the market when it zigzags on its way up.

Before we discuss the relationship between market volatility and index performance, it is important to first define “volatility spike.” In particular, market participants should focus on what level of volatility is considered to be high and what kind of volatility movement is a “volatility spike”.

For our analysis, we will first compute market volatilities using a 21-trading-day rolling window and then use the one-year median to evaluate realized volatility. We will consider volatility above its one-year mean as a spike and deem this level as high.

When it comes to volatility distribution, either implied or realized, the sample median is usually more representative than the sample mean. The distribution of VIX® levels and the equity market’s 21-trading-day realized volatility in the past 10 years clearly shows that implied and realized volatilities were heavily skewed (see Exhibit 1). Although the majority of the data points clustered to the left of the distribution, the fat tail on the right significantly pulled the sample mean above its median. Exhibit 2 further confirms that average volatility was higher than median volatility. Note that the 2008 financial crisis data was not included in this sample set; otherwise, the gap between mean and median would be even larger.

Furthermore, using a relatively short lookback period can help us identify local volatility spikes that are relevant to market performance. We can see from Exhibit 2 that mean and median vary, depending on the length of lookback period, indicating volatility regime shifts in history. The realized volatility of the S&P 500 in May 2019 was 14.29%. It may look tame compared with the index’s long-term average volatility (17.5% since 1990), but it has more than doubled from one month ago (6.14%).

We plotted the monthly excess returns of the S&P 500 Low Volatility Index over the past 10 years against the broad market monthly volatility (see Exhibit 3). We also included the one-year moving average and the moving median of 21-trading-day market volatilities, both calculated daily.

We can make the following observations from the past 120 months.

  • The volatility spiked 51 times, 34 of which had positive excess returns. In other words, if volatility rose above its one-year median, the probability of the S&P 500 Low Volatility Index beating the market was 67%.
  • The S&P 500 Low Volatility Index outperformed in 56 months; 61% of those months also had volatility spikes.
  • We saw 17 months in which the S&P 500 Low Volatility Index had excess returns greater than 2%. Out of those 17 months, 14 of them (82%) were also months with volatility spikes.

Exhibit 2 also shows that the mean and median of market volatility in the past year exceeded those of the past five years, suggesting that the market might be gradually moving out of its low volatility regime of recent years. The widening spread between the one-year mean and one-year median also reminds us of the shocks in late 2018.

It would not be surprising for market participants if low volatility factor strategies continued to perform better than a rising equity market, as long as volatility remained above its median.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Do Active Funds in India Benefit from Higher Active Risk Exposure?

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Akash Jain

Director, Global Research & Design

S&P BSE Indices

Fund managers typically follow a factor or a style of investing and aim to construct portfolios by balancing active sector exposures and stock-selection risks within a sector. Tracking error is one way to measure a fund’s deviation from its respective benchmark to determine how “active” it is.

As measured in the SPIVA® India Year-End 2018 Scorecard, in the Indian Equity Large-Cap category, fund managers undertaking higher active risk posted higher returns. The large-cap category is generally the most researched and most efficient segment in any market, and it is therefore extremely challenging to generate outperformance in the active space. As shown in Exhibits 1 and 2, in the large-cap category, fund managers who took higher risk (had a higher tracking error) delivered superior returns relative to their peers. In other words, funds taking higher active risk were compensated with higher excess return and thus, had higher information ratios. But looking at the category average, active funds had little to offer in terms of excess returns.

On the other hand, in the Indian Equity Mid-/Small-Cap category, funds with lower tracking error or funds that were more closely aligned to the benchmark outperformed their peers. Alternatively, Exhibits 1 and 2 imply that fund managers in this category who took on higher active risk in their portfolios found it challenging to get their active bets correct, thus witnessing lower information ratios. Having said that, we see that active fund managers in this category, on average, still generated excess returns over the benchmark.

In summary, in the Indian Equity Large-Cap category, active funds with higher active risk have historically offered positive excess returns and positive information ratios, but the overall category average shows that the category has underperformed the benchmark. Interestingly, in the Indian Equity Mid-/Small-Cap category, funds with lower tracking error have offered better excess returns and thus higher information ratios, with a mean excess return of 103 bps.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Implied Plunge Protection

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

Ever since its formation in response to the “Black Monday” crash of October 1987, the United States “Working Group on Financial Markets” has been accompanied by (persistently-denied) rumours that the group used government funding to make large equity purchases whenever the market fell – giving rise to its informal moniker of the “Plunge Protection Team”.  While few still believe that the original “PPT” are busy buying the dips, a modern version may have emerged in the current combination of U.S. political and fiscal priorities.  The effect is most visible in the collapsing cost of insuring against large downside moves in the S&P 500®.

The Cboe Volatility Index (“VIX®”) provides a highly useful snapshot of short-term risk sentiment for the S&P 500 – it provides the “implied” annual volatility of the S&P 500 price index over the next month.  If volatility expectations are higher, the chance of a large down day increases.  After rising in December, VIX has been grinding down recently, closing on Monday at a paltry 12.68.

Exhibit 1: Cboe Volatility Index (VIX) year to date as of July 12th, 2019

If equity returns were normally distributed, then volatility would be all one needed to know to describe equity risk.  However, they aren’t, and so it isn’t.  Instead, equity returns are negatively skewed: declines three standard deviations below the mean have occurred much more frequently than gains three standard deviations above the mean.   In fact, if we take the prior day VIX as a prediction for the next day’s (annualized) volatility, declines that should be much more rare have occurred once or twice each decade.

Exhibit 2: “Impossible” daily moves in the S&P 500 (Jan 1990 – Jun 2019)

Note that although September 2008’s single-day decline of 8.79% is the largest in absolute terms, it was not the most “surprising” in our sample: the high reading of VIX on the previous day was already sounding the alarm of higher standard deviations.

Taking Skew into Account

If “tail” events are more likely than we would otherwise expect, we need to know how likely it is that a 3, 4 or 5-standard deviation move might occur (or at least, how much it costs to insure against one).  Conveniently, there’s an index for that!  The Cboe SKEW index uses the prices of S&P 500 options with different strikes to derive an implied “skew” of the distribution of future returns.  While skew has a formal mathematical definition, for practical purposes what we need to know is that its magnitude reflects the implied probability of a multiple-standard deviation loss.  Here is a chart of the implied 1-month skew in the S&P 500 for the past 15 years; we plot a 60-trading day average to illustrate the broader trend.  Notwithstanding a few bumps along the way, the series gains gradually from late 2008 through to a peak last September, but has fallen dramatically since then.

Exhibit 3: The 2019 Collapse in S&P 500 Skew

The perspectives of skew and volatility provide two dimensions in which the market can warn of a large decline.  VIX measures the cost of protection in general, whereas skew tells us if protection against larger moves is especially expensive relative to smaller moves.   Since surprises can occur even when we don’t expect them, skew has historically tended to reach its highest readings when VIX was low.  Exhibit 4 demonstrates this phenomenon based on daily closing levels over the past 15 years; the levels since the start of June 2019 are highlighted.

Exhibit 4: VIX and skew, historic and recent

What Exhibit 4 illustrates is that – at present – options linked to the S&P 500 imply that we’re set for low volatility, and unusually low skew compared to recent times.  That means that the market is charging considerably less than usual to insure against large down movements, and while market sentiment regarding risk can certainly be wrong, it does help explain what is going on at present.

Plunge Protection … but for how long?

Of course, it is one thing to note that the market doesn’t seem worried about a nasty shock, and quite another to speculate on the causes of such potential complacency: there is a very obvious candidate provided by the combined efforts of politicians and central bankers.

The U.S. Federal Reserve has committed to keep the economic expansion going, boosting market confidence that they will turn on the taps in response to equity weakness.  The Fed’s change in course in January after the equity market selloff was a major indicator here, as was the “good news is bad news” reaction that markets gave to a healthier-than-expected jobs figure on July 5th.

But the Fed is not going it alone; the Trump administration has made it clear that they view the equity market’s performance as a validation of their efforts to support the economy, and would appear to have a keen desire to keep the markets rising at least until the Presidential election.  The combined efforts of both fiscal and monetary powers seem aligned in an effort to prevent downside equity moves … at least in the near term.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

2019 Mid-Year Persistence Scorecard - Key Highlights

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Hamish Preston

Director, U.S. Equity Indices

S&P Dow Jones Indices

When it comes to investing, market participants often consider past performance to be indicative of future results.  The same goes for fund selection.  Notwithstanding the evidence showing that most active managers in most regions typically underperformed their benchmarks, consistently beating peers is one way to differentiate a manager’s luck from skill.  Here are a few highlights from our newly released Persistence Scorecard, which examines the extent to which funds that outperformed their peers maintained their status thereafter.

1. Shorter-term performance persistence rose but was absent in many categories over longer horizons.

Over the three-year period ending March 2019, there was an uptick in the performance persistence of smaller-cap equity managers compared with results from six months prior:  23.3% (versus 7.7%) and 13.7% (versus 4.0%) of small- and mid-cap equity managers, respectively, remained in the top quartile during the three-year period ending March 2019.  But showing how difficult it can be to beat peers over longer horizons, zero top quartile large-, mid-, and multi-cap equity funds maintained their status at the end of the five-year measurement period.

2. Top performing funds were more likely to become the worst-performing funds than vice versa.

Exhibit 2 provides a breakdown of the movements between quartiles over two non-overlapping five-year periods for domestic U.S. equity funds.  More than 50% of all top quartile funds became bottom half funds, with 31.53% moving to the bottom quartile.  This suggests that market participants may wish to be careful when using past outperformance as a guide for future results.

Additionally, Exhibit 2 highlights the potential challenges with betting on a turnaround in a fund’s performance.  While 15.26% of bottom quartile funds moved to the top quartile, 26.51% were merged or liquidated, higher than for any other category.

3. Many fixed income managers appeared to be wrong-footed by the bond market.

The bond market has gone through a turnaround recently; after a sustained period of tightening monetary policy, expectations changed in Q4 2018.  Concerns over growth and the potential impact of a trade war led many people to believe that the Fed would cut rates.  Against this backdrop, many fixed income managers that outperformed their peers as of March 2017 and March 2018 (when rate hikes were expected) were unable to maintain their status over the 12-month period ending March 2019.

As a result, our latest persistence scorecard shows just how challenging it has been for managers to consistently beat their peers, especially over longer horizons when market environments are more likely to change and competitors may become wise to (relatively) successful strategies.  Market participants may therefore find it useful to keep in mind that past performance is no guarantee of future results.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Corn Pops to a New High

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Jim Wiederhold

Director, Commodities and Real Assets

S&P Dow Jones Indices

Several catalysts, including U.S. Corn Belt production issues, drove corn futures prices to a new five-year high in June 2019. Investors were net short corn in May 2019, and the short covering contributed to the break higher. Prices broke through the 2017 peak after heavy floods in the Midwest prevented farmers from planting corn in a timely manner. While they have typically finished planting by May, this year U.S. farmers continued to plant until the end of June. As seen in Exhibit 1, it took a full extra month to get the crop planted. With new farming technology, farmers are able to plant 24 hours a day and can get the crop into the ground quickly when given the opportunity. This season, the new U.S. farmer bailout package encouraged farmers to continue planting even under less-than-ideal conditions because government payments are based on acres planted.

There are risks associated with planting corn so late in the season because it can negatively affect the final yield, and this is already apparent with 2019’s crop conditions. As can be seen in Exhibit 2, farmers are experiencing some of the worst crop conditions of the past five years. At this point in the season, we have not seen lower rated conditions since 2012. According to Farm Futures, growers continue rating crop conditions behind those reported in the USDA Crop Progress report. This leads to speculation about how the final crop will turn out, with the potential for a significant cut to supply affecting prices in the second half of 2019.

In past similar scenarios (like in 1995), corn prices moved higher throughout the growing season and the bull run continued into the end of the year after the harvest verified that the poor crop conditions had translated into a lower yield and a smaller crop. This year, much will depend on weather conditions over the remainder of the growing season and, possibly more importantly, the final acreage number. Many market participants expect that the final acreage level will eventually be adjusted lower to reflect the late planting pace.

The S&P GSCI Corn offers market participants the ability to capture these idiosyncratic movements. The index was up 12.655% YTD as of July 11, 2019. Supply shocks can drastically affect the price of the underlying commodities in agricultural markets. Tactical investments in commodities when the conditions are good offer an interesting return stream for investors. This recent move in corn is an example of how an allocation to commodities can do just that.

The posts on this blog are opinions, not advice. Please read our Disclaimers.