Why volatility investing isn’t appealing to asset owners
The white-knuckle ride of global capital markets over the first few months of 2018 have raised the profile of some volatility investment options. But Asian investors appear to be eyeing these products very warily.
Market peaks and troughs have been particularly evident in US equities. Since the beginning of the year the S&P 500 Index soared to a record high of 2,872 on January 26, before plummeting 10% to 2,581 on February 8, recovering 8% back to 2,786 on March 9, and then reversing once more to 2,581 on April 2.
These market jitters stand in stark contrast to the predictable times of 2017. The Volatility Index (Vix), a key gauge of investor fear in the equity market, stood at 11.04 at the end of last year, only to surge to 37.32 on February 5–it rose briefly to over 50, its highest level since August 2015. The index recovered somewhat to close at 23.62 on April 2.
Vix was introduced by the Chicago Board Options Exchange (Cboe) in 1993 as an indicator of near-term volatility in the S&P 500 index. However, the index itself is not investable. Investors can trade volatility only after the Cboe has had Vix futures and options since 2004 and 2006, respectively. Such derivative products allow willing investors hedge or generate active returns on broad market volatility.
Given recent market conditions, it seems sensible that more Asian investors are considering these options.
“Anecdotally we would say that the interest from Asian customers is growing,” said Michael Mollet, Chicago-based director of product development at Cboe Global Markets.
To date, the main interest has been from hedge funds. Asset owners in the region are still evaluating how such alternative assets fit in their investment portfolios, he said.
“They are kind of determining, ‘how do I implement them [volatility products]? Is it something that we have the expertise in-house to do? Is it something that I would outsource to another person?’” he said.
“These are some of the issues that asset owners, and probably some insurance companies, are working through before they really start trading in a meaningful way,” he said.
That view could well be too optimistic. Many leading Asian investors feel Vix strategies to be unfit for strategic asset allocation and too complex to use tactically.
VOLATILITY TO STAY
Most of the region’s leading asset owners understand that the benign market conditions that had marked US equity markets over the past few years have come to an end.
Equity volatility has been fed by a mixture of historically high equity valuations at the end of 2017, combined with US president Donald Trump’s frequent tweets about his desire to engage in trade wars and tear up existing trade agreements such as the North American Free Trade Agreement. The US government imposed tariffs on foreign steel and aluminium in March, which led China to retaliate by placing tariffs on $3 billion of products from the US. Investors fear these tit for tat measures could expand into an all-out trade war between the world’s two largest economies.
“The biggest downside risk this year is equity market volatility … The volatility in this year will be higher than last year,” Sophia Cheng, chief investment officer of Cathay Financial Holdings, told AsianInvestor. Taiwan’s Cathay Financial Holdings is the parent company of Cathay Life, which had an investable asset of NT$ 5.5 trillion ($189 billion) as of end 2017.
She believes a structural element is adding to the level of market volatility, in the form of index mutual funds and exchange-traded funds (ETFs). Passive investment vehicles issued in the US with exposure to local equities rose from $2.73 trillion in 2015 to $3.64 trillion at the end of last year, an increase of 33% according to research consultancy firm ETFGI.
Cheng said this increasing amount of buy-and-hold money in the stock market helped push equity valuations up last year. That led some active investors who found valuations to look too expensive to exit, causing a market correction until valuations fell to a level where they were willing to buy once more.
She expects to see similar seesaw effects going forward, courtesy of the inertia offered by passive money. “In 2018 I think the frequency of sizable volatility will be much more obvious than in 2017.”
But that doesn’t mean Vix products are the answer. For a start, long-term investors don’t feel the products are appropriate for strategic asset allocation.
“Investing in volatility does not meet insurers’ need for long-term investing. They [volatility products] are very short-term,” the Hong Kong-based head of investment solutions and derivatives of an international insurer, told AsianInvestor.
Insurers sell long-term products that span decades, and derivatives that only last for two to three months don’t help match those needs, the investment solutions head said.
Unlike stocks which can give investors dividends and potential upside in value, a buy-and-hold strategy naturally does not work for derivative products of futures and options as they expire after some time.
Liu Li-ju, deputy director general of Taiwan’s Bureau of Labor Funds (BLF) also said the pension fund was staying away from the derivative products. “We won’t invest in Vix products. Frankly speaking they are not in our investment scope,” she said.
“We want long-term stability in returns, and not a gambling-like investment act at a specific point of time or around a short period of time.”
Cathay Life is not considering using such instruments to invest. Cheng said it comes down to risk versus reward. “Whatever assets can be traded, what one has to consider is if you get it wrong, how sensitive it is to your shareholders’ value? How big is your dedicated team? Can you justify the resources [that you spent] for the gain?”
She thinks the risks don’t normally merit the reward.
“Trading volatilities is the same as trading second derivatives. It’s calculus of calculus. The risk it involves, especially unexpected event risk, is high.”
Insurance companies don’t want to be seen as aggressive risk takers, as this could affect their share prices, she noted.
Insurers also typically lack the expertise to utilise such products, the unnamed insurance executive said, adding that he turned down some European banks that were pitching him similar products four years ago.
“It’s generally difficult to understand the mechanism and methodology behind such volatility trading strategies. It depends on individual cases, but in some occasions people will think it’s like black-box,” Janet Li, wealth business leader for Asia at Mercer, told AsianInvestor.
Look out for the second part of this feature story from our April/May magazine, when we look into whether volatility instruments will ever appeal to them.