An Analysis Of Why Volatility Indexes Are Still Relevant
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.
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.
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 percent were confident, 6 percent were very confident; 23 percent not confident and 8 percent not confident at all.
- If 54 percent 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 percent 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 percent of the respondents believed their local equity market would be positive.
In 2014, 62 percent percent believed their local equity market would rally. By parsing the survey regionally, the European respondents went from 59 percent positive in 2013 to 64 percent in 2014. The North American respondents went from 74 percent in 2013 to 69 percent in 2014. The percentage dropped a little in North America, but is still relatively high.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
© 2016 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.