Financial markets are about making decisions in moments of uncertainty. The one certainty one can make is that no one has a crystal ball, nor can anyone predict with certainty what will occur in the future. Although seeking methods to manage portfolio volatility and tail risk may fall out of fashion from time to time based on market sentiment, it should always be utilized as part of the risk management process. Volatility indexes are instruments that may assist in the risk management process.
In the capital markets when participants ask if a product is still relevant is often when the product finds itself out of favor. Sometimes that is when the product is at its lowest point just before it becomes relevant again and back in favor. This was exactly the situation that occurred with volatility indexes during the summer of 2014.
Last July, Japan was reported to be leading the global decline in volatility to the lowest level in seven years. The U.S. market this past summer witnessed the VIX reaching lows not seen since pre-financial crisis days and market participants asking if volatility is too cheap. The VSTOXX® spot index derived from the EURO STOXX 50® Index also found itself near historical lows recently as noted in Chart 2.
Volatility is a function of sentiment: If investors believe the near future is less certain, volatility may increase and the shape of the VSTOXX® Futures curve could move from contango to backwardation. Or if investors are more optimistic for the near future, volatility may decrease. For example:
The Euro Area Sentix Investors Sentiment index turned positive in the fall of 2013 and remained positive until September 2014. The Euro Area Zew Investors Sentiment index has remained positive since January 2013. Although still positive, the Zew index has trended lower since January 2014.
- Earlier this year ConvergEx Group released a European Equity Market Structure Survey and asked “How confident are you that the European equity markets could handle the volume created by a sudden geopolitical crisis or other large volatility shock?” 40% were confident, 6% were very confident; 23% not confident and 8% not confident at all. If 54% are less than confident, than seeking various methods to absorb the volatility shock such as VSTOXX® Futures may offer some assistance. But it may be similar to fire insurance; you need to have it before the fire occurs instead of trying to obtain the insurance during the fire.
- July 2014 ConvergeEx Group survey of U.S. investors asked the following question “Do you believe investors in the capital markets are too complacent at the moment, given historically low volatility levels?” 66% of the respondents agreed investors are either complacent or much too complacent.
- A Forbes article last March mentioned fund managers believe investors were increasing their allocation to European equities and an increased sentiment of economic growth of the Euro area.
- The annual Global Sentiment Survey for 2014 conducted by Franklin Templeton Investments found an increased positive sentiment for equity markets. In 2013 55% of the respondents believed their local equity market would be positive. In 2014 62% believed their local equity market would rally. By parsing the survey regionally, the European respondents went from 59% positive in 2013 to 64% in 2014. The North American respondents went from 74% in 2013 to 69% in 2014. The percentage dropped a little in North America, but is still relatively high.
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Copyright ©2014 Mark Shore. Contact Mark Shore for permission for republication at firstname.lastname@example.org Mark Shore has more than 25 years of experience in the futures markets and managed futures, publishes research, consults on alternative investments and conducts educational workshops.www.shorecapmgmt.com
Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business, where he teaches the only known accredited managed futures course in the country. He is also a Board Member of the Arditti Center for Risk Management at DePaul University.
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Futures and options can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.