Volatility Spikes! Time to Get Active?

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Volatility in stock markets spiked last quarter and the S&P 500 had its worst quarterly performance since the 3rd quarter of 2011. Many investors call the VIX index the “fear index” as it reflects the relative degree of volatility in the S&P 500. For perspective the VIX has averaged 20.33 over the last 10 years, reaching a peak of just over 80 during the financial crisis of 2008 while hitting its low of just under 10 in January 2007. During this time the VIX has been in a fairly narrow range, fluctuating between 10 and 20, but it has topped 40 three times since 2008. The first time was in May 2010 during the “flash crash”, where stocks quickly plummeted 9% and then reversed course, all within the space of 36 minutes. The next spike in volatility came in mid-2011, when Standard & Poor’s decided to downgrade the debt rating of the United States Government. The third time, you ask? August 2015, as the Chinese government nudged their currency lower signaling perhaps a slowing economy in China and the emerging markets as a whole.  In all 3 cases, returns for the quarter were negative, over 10% for the flash crash quarter, over 13% for the US downgrade quarter and 6.44% for Q3 2015. While stocks rallied strongly in the year that followed both the flash crash and the debt downgrade, it is far from clear that history will repeat itself.

The occasional spikes in the fear index can be unnerving to investors, especially those who may have assumed more risk recently in response to the zero interest rate regime. And the most recent spike in the VIX comes on the tail of disappointing year-over-year performance for the equity markets. The bond market is not much help today either, with yields remaining in very low single digits. We may be entering a period where return expectations for both stocks and bonds are lower than historical averages.

Part of the solution may be to look to actively managed portfolios that focus on both delivering returns and managing risk. While all portfolio managers should have a system for managing the risk in their portfolios, not all portfolio managers have a target range for the volatility of portfolio returns. We have all heard that risk and return are positively correlated, meaning that you generally cannot earn higher returns without assuming higher levels of risk. Most investors move along the spectrum between stocks and bonds to achieve the desired balance of risk and return. More bonds, less risk and vice versa. With expected bond returns well below their historical average however, is there a way to achieve reasonable returns without the historical risk of the equity market? We think that certain low volatility, absolute return funds can provide a risk/return profile that sits in between stocks and bonds on the risk/return spectrum.  Such funds can be used to play defense from an equity perspective or offense from a bond perspective. The last 6 years has been all about beta, as US stock market indices have done well both on an absolute basis and a relative basis. Going forward we may be better served by active management of both risk and returns.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM
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