Volatility is coming. Are you prepared?

Oct 1st, 2020 | By | Category: Alternatives / Multi-Asset

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By Pierre Debru, Director of Research, WisdomTree.

Volatility is coming. Are you prepared?

Volatility is coming. Are you prepared?

Upon entering the fourth quarter of a literally unbelievable year, it feels like the world is waiting for the next “thing” to happen. Investors already had to contend with the fastest bear market in history, the fastest recovery, a tech boom…What now?

Listening to market participants and looking at the CBOE Volatility Index (VIX) market, in particular, it appears that more volatility could be next. With a new increase in COVID-19 infections and the US election on the horizon, this would not be very surprising.

Volatility is usually the poster child for unpredictability. Changes in VIX regime are notoriously hard to anticipate. However, for once, volatility may have sent us advance notice. So, to prepare for Q4, investors could look back at what worked historically and what did not.

From our own analysis, it is clear that some strategies are more suited to a period of increased volatility and risk:

  • among equities strategies, Quality stands out with a balanced performance profile, protecting portfolios when risk is rising and benefitting from the normalizing period after
  • diversifying assets like Gold and Long Duration government bonds typically provide a very nice buffer both before, during, and after the increase in volatility.

The market expects the months of October and November to be very volatile

2020 has proved to be a high volatility year, but looking forward, volatility traders are pricing, and have been pricing for a while, an even more volatile autumn. From a VIX at 25 currently (as of 14 September), traders are seeing levels upward of 30 a few weeks down the line. Whether this increased volatility is the result of a jump in coronavirus infections, uncertainties around a potential vaccine, a disputed US election, or signs of weaknesses in the current tech led rally, does not dramatically change the stark message to investors: “Prepare!”

Source: WisdomTree.

Source: WisdomTree.

Which assets resisted the best to the most recent volatility spike: Gold, Long Duration Government Bonds, and Quality

Assuming that volatility is coming, then what is the smart choice for a portfolio? How to protect and benefit from such a period? As always, history is an excellent teacher.

In this blog, we aim to study the behaviour of different assets around changes in volatility regimes i.e. before, during, and after the volatility spike itself. To do so, we consider three different periods:

  • the 2 months that precede a daily spike in VIX
  • the 2 months that follow a daily spike in VIX
  • the 4 months around a daily spike in VIX (2 months before and 2 months after)

As a first step, let’s look at what happened this year around the biggest volatility spike (+24.86 on 16 March 2020).

In Figure 2, we observe that the strongest performers before the spike were Government Bonds, Gold, and Min Volatility. After the spike, though the best performers were Gold, Growth, and then Momentum and Quality tied for third. These are two very different lists; one is more defensive and the other one is more cyclical in nature. So which asset did the best over the whole period?

In the multi-asset realm, Gold benefitted the most, of course, being in both top three and benefitting from its all-weather behaviour. Long duration government bonds followed just after. In the equity world, Momentum, Growth, and Quality did the best. Momentum and Growth got pushed by the Tech rally in Q2 and Q3 and Quality benefitted from its balanced profile, doing well before and after the spike.

Source: WisdomTree.

Source: WisdomTree.

All-weather assets, like Gold and Quality, are particularly suited to navigate the lead-up and the aftermath of a volatility spike

Trying to generalize our findings further, we look at the lead up and aftermath periods to all volatility spikes since 2002. A volatility spike is defined as an increase in VIX of 5 points or more.

In Figure 3, we can clearly see that:

  • Defensive assets tend to do very well in the period preceding the volatility spikes. The Top 4 performers in those lead-up periods historically have been Gold, EUR Government Bonds, Min Volatility Equities, and Quality Equities. Over those two months, Gold has outperformed Global Equities on average by 13.1%, government Bonds have outperformed by 9%. In the equities, Min Volatility has outperformed by 3.8% and Quality by 1.8%. Those results are very consistent with our observation in March 2020.
  • In the aftermath, i.e. in the period immediately following the volatility spike, the Top 4 is quite different. First comes Gold with 2.8% average performance over the period (vs +0.5% for Global Equities) then Quality just behind with +2.6%. Government bonds are third and Growth and Momentum are tied for fourth with a positive performance of 1.17% over the 2 months. Again, those results are quite similar to our observations in Q1 this year. It is worth noting though, that Growth and Momentum have “outperformed” their historical average this year thanks to the current Tech rally which may or may not continue in the last quarter of the year.
Source: WisdomTree.

Source: WisdomTree.

What these two analyses show is that historically the assets the best suited to deal with periods of heightened volatility are all-weather type assets i.e. assets with strong defensiveness in the downside and with the capabilities to capture a large part of the upside. In our analysis such assets have proven to be:

  • Quality Equities
  • Long Duration Government Bonds
  • Gold

Looking ahead, many investors are formulating their views and resulting asset allocation on potential election results. If a democratic administration plus a democratic congress took control, there could be more spending which could eventually lead to higher inflation. If Republicans were to maintain control, that could possibly mean lower tax rates for a longer time and less fiscal restraint. Massive time and research are spent on analyzing individual companies with these possibilities in mind. However, we do not find as many people framing their considerations of equities, fixed income, or gold purely from the standpoint of wanting to be reading for higher volatility.

Dialing up gold, long-duration government bond, and Quality exposure, as one example, could be a good step towards ‘volatility readiness’ in light of historical patterns and the upcoming uncertainty in the markets.

Global equities are proxied by the MSCI World Index. Min Vol is proxied by MSCI World Min Volatility Index. Quality is proxied by MSCI World Quality Index. High Dividend is proxied by MSCI World High Dividend Index. Value is proxied by MSCI World Enhanced Value Index. Momentum is proxied by MSCI World Momentum Index. EUR Gov is proxied by Bloomberg Barclays Euro Aggregate Treasury Index. EUR Gov 10+ is proxied by Bloomberg Barclays Euro Aggregate Treasury 10+ Index. Gold is proxied by LBMA Gold Price PM USD.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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