After months of complacency, volatility is coming back amid concerns about the escalation in the Middle East and Asia and the upcoming presidential elections in France. The VIX index has surged to the level of 16, an almost 50% rise compared to the minimum touched last month and the highest level since last November.
This move is once again a signal that we are living in a world with multiple geopolitical risks, symptoms of which materialize as sudden spikes in volatility, as we have highlighted in the recent paper “Geopolitics and Investing: The Normality of the Unexpected”.
Re-Surging Volatility (VIX Index)
Source: Pioneer Investments, Bloomberg. Updated at April 18, 2017.
However, while volatility has only recently surged (it still remains quite low on a historical standard, with a longer term average over the last 20 years of 21 for the VIX), the perception of “tail” risk is now at historical highs. This is measured by the skewness implied by the equity options market, which in our view better captures this concept. (Skewness refers to the asymmetry from the normal distribution in a set of statistical data.) The CBOE Skew Index (SKEW) is “an option-based indicator that measures the perceived tail risk of the distribution of S&P 500 log returns”. This index has reached a new high in mid-March, signaling that the perceived tail risk in the market is very high, despite the low volatility environment experienced in the last few months.
In my opinion, the recent rise in volatility is directly linked to the geopolitical trends mentioned above, as these may take longer to unfold and provide no clarity on their implications on the economy and markets at this stage.
With tail risk being the new normality, I think that portfolio construction should have a strong focus on drawdown management through the hedging of alternative scenarios. A way of doing this, in our view, is by listing the main risks to the base scenario and attributing these with a probability of occurrence. It’s also important to try to estimate their possible impact on a portfolio through stress test scenarios. This allows events – that could either have an high probability of occurrence or have a significant negative impact on investor’s portfolio – to be identified, measured and managed in their consequences.
Pioneer Investments’ Top-Down Risk Monitor
Source: Pioneer Investments. Data as at April 18, 2017.
So what can investors do in this framework? One option is to implement hedging strategies that can help to limit a portfolio drawdown, should one of these events occur.
However investors should be aware of two things: first, hedging against every risk is technically possible but practically impossible. It’s too costly and would limit portfolio returns over the long-term, constraining the sources of “active risks”. Second, hedging is more an art than a technique. Not all the hedging strategies are effective in the same way to protect against a specific risk. Based on market conditions (volatility, implied costs, risk sentiment etc), it’s in my view important to identify the “best hedging” to achieve a pre-defined investment goal.
Gold, in my view, is an effective hedging implement in this phase against geopolitical risk and potential spikes in volatility. Currencies, such as the US dollar, can also play a role in hedging against tail risk events, because they are catalysis of the “safe heaven” investors’ demand.
USD as a Hedge Against Geopolitical Risk
Source: Pioneer Investments, Bloomberg. Data as at April 13, 2017.
In addition, the ability to take directional market views through options can also be of benefit in a period of relatively low (but rising) volatility, positive economic backdrop and tail risk. For example, getting exposure to an index through a call option can limit the downside (the cost of the call option) while keeping the portfolio free to participate in a potentially unlimited upside.
So all in all, we believe that in this phase it will become more and more important for investors to understand the risks and try to manage them in an effective way, to build resilient portfolios in a world where the unexpected is becoming the new normality.