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Should investors be concerned about the VIX?

| May 12, 2017
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Recently, the CBOE Volatility Index, commonly referred to as the VIX, dropped below 10%. This occurrence caused a few headlines because the other name for the VIX is “the fear index”, so a drop below 10 – which hadn’t occurred since 2006 – raises concerns that investors may be too complacent and may be under-appreciating the potential risks in equity markets.

Whether this assertion is true or false is a reasonable financial question: Do investors think that signs of stronger global growth, the election of a pro-EU candidate in France, and generally accommodative central bank policies will all serve to keep future market movements somewhat muted? Are market participants discounting the possibility of market unrest stemming from Fed rate hikes, a slowdown in China, or strife between the U.S. and North Korea?

I don’t think so.

While the VIX is very low historically, it is important to note that realized volatility is also extremely low. Let me back up for a moment and provide some background: the VIX measures the ‘implied’ volatility of S&P 500 index options and is a measure of expected future volatility; Realized volatility, on the other hand, is exactly what it sounds like - the actual volatility that the S&P 500 has experienced over the last month. It makes sense that future expectations (the VIX) are impacted by the level of current movements (realized volatility) in the stock market. So, when actual volatility is low, investors should expect the VIX to be low as well. Since realized volatility over the last month is around 7%, perhaps the VIX falling below 10% is reasonable.

To assess this further, investors need to consider the relationship between the VIX and realized volatility to see if the spread between the two is relatively normal. Most of the time, the VIX is greater than realized volatility because, since index options can serve the purpose of hedging portfolio risk, investors are often willing to overpay for them like they would for other insurances. (In this case, the overpayment goes to a financial institution acting as a market maker instead of going to an insurance company). The extent of this difference should provide some idea as to whether investors are excessively worried or not. For instance, if the spread is excessively narrow, it would mean that the VIX is historically low relative to realized volatility which would indicate a high level of investor apathy.

Reviewing the data, it appears that over the past 5 years the VIX is, on average, about 3.4 higher than realized volatility. As of this writing, this spread is right around 3.0 – very close to average (in the 42nd percentile to be precise). This indicates that investors are pricing options/insurance (relative to actual volatility) at close to historic norms. No complacency here.

As further support for the view that investors aren't acting too carefree with respect to the potential for upcoming market turmoil, I’d point out that investment flows over the last few months have been into bonds and bond funds. These are generally lower risk investments and demonstrate that investors aren’t allocating to high risk assets. This risk aversion seems to indicate some level of investor concern with equity markets at this time.

Ultimately, the VIX is an interesting metric, has its uses, and may be good for a headline on occasion, but in isolation it doesn’t tell us much. Investors should keep the big picture in mind and stick to their long-term asset allocation plans. That way, regardless of whether or not the market experiences turbulence, investors will remain on course.

Have questions about the VIX or how to navigate market volatility? Contact me at andrew@lpastrategic.com.

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