Will the Real Min Vol Please Stand Up?
It would be perfectly understandable if market volatility followed the anguished and uncertain headline news from around the world. Despite some recent, short-lived spikes tied to geopolitical risks out of North Korea, the CBOE Volatility Index (VIX) – widely referred to as the “fear index” because it tracks the U.S. equity market’s expected 30-day volatility – has remained near historic low levels. Since 1990, the VIX has averaged around 20, and we have not seen persistent expectations of volatility for some time. Within the trailing one-year period, only two trading days saw a closing VIX level above the average. November 4, 2016, just before the U.S. presidential election, was the last day a closing level above 20 was reached. So far this year, there have been more days where the VIX has closed below 10 than any other calendar year dating back to 1990. In fact, the number of days below 10 in 2017 has reached a total of 18, which exceeds all previous days below this level (15) over the past 27 years.
Figure 1: Historical VIX Levels (1990 – 2017)
Source: Bloomberg, 8/14/2017. The CBOE Volatility Index® estimates expected volatility by averaging the weighted prices of S&P 500® Index (SPX) puts and calls over a wide range of strike prices. Past performance is not indicative of future results. An investment cannot be made directly in an index.
While the VIX is at historic lows for now, by nature, it is prone to unexpected spikes. As such, it is important to look at how various equity strategies fared during elevated periods of uncertainty. Figure 2 depicts daily performance during periods of uncertainty (days the VIX is greater than 20). Low/min volatility strategies fared better than the S&P 500 as a whole during these time periods, but still produced negative cumulative returns. Notably, merger arbitrage strategies, represented by the HFRX ED Merger Arbitrage Index, returned positive cumulative returns. As I wrote about earlier this year, merger arbitrage strategies seek to profit from the price discrepancy between a stock’s price after the public announcement of a merger and the completion of the deal. The asset class is typically used as an alternative to equities; it uses market hedges (shorts1) to dampen portfolio volatility and reduce correlations to the equity markets.
Figure 2: Cumulative Daily Returns when the VIX Is Greater than 20
Source: Bloomberg, daily returns from 3/31/2003 – 7/31/2017. Past performance is not indicative of future results. An investment cannot be made directly in an index.
Investors typically turn to low/min volatility products when seeking to create a more defensive equity allocation. They seek to limit the range of returns experienced around the mean. Standard deviation2 is a measure of this risk and is a common measure of volatility. Figure 3 depicts how low/min volatility strategies have mirrored equity markets directionally in terms of risk. On average, in the time periods shown below, a low/min volatility strategy had a 23-26% reduction in standard deviation over the S&P 500 Index. The resulting risk levels are still significantly higher than the 3.04% average provided by the HFRX ED Merger Arbitrage Index. Merger arbitrage strategies have maintained both a consistent and lower level of standard deviation over time.
Figure 3: Rolling Three-Year Standard Deviation
|HFRX ED Merger Arbitrage||3.04|
|S&P 500 Low Volatility||10.65|
|MSCI USA Min Vol||11.04|
Source: Morningstar, 7/31/17. Past performance is not indicative of future results. An investment cannot be made directly in an index.
Merger arbitrage strategies can be a good, long-term option for suitable investors looking to lower equity volatility. On average, merger arbitrage has historically reduced volatility, as measured by three-year standard deviation, by roughly 78%, when compared to the S&P 500 Index. Based on historical behavior, the volatility of merger arbitrage strategies remained low, even when expected volatility increased.
1. Standard Deviation is a measure of the extent to which observations in a series vary from the arithmetic mean of the series. This measure of volatility or risk allows the estimation of a range of values for a manager’s returns. The wider the range, the more uncertainty, and therefore, the riskier a manager is assumed to be.
2. A short is an investment strategy where the investor sells shares of borrowed stock in the open market. The expectation of the investor is that the price of the stock will decrease over time, at which point the he will purchase the shares in the open market to make a profit.
The CBOE Volatility Index® (VIX® Index) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.
The HFRX ED Merger Arbitrage Index is designed to be representative of the overall composition of the hedge fund universe implementing a merger arbitrage strategy. Merger Arbitrage strategies employ an investment process primarily focused on opportunities in equity and equity related instruments of companies which are currently engaged in a corporate transaction.
The S&P 500® Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.
The MSCI USA Minimum Volatility Index aims to reflect the performance characteristics of a minimum variance strategy applied to the large- and mid-cap USA equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, in USD for the lowest absolute risk (within a given set of constraints).
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.
Securities are distributed by NYLIFE Distributors LLC, located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.