Thursday, 10 May 2012

Investing in Fear: Part One

Ever since the financial storm of 2008 blew Lehman Brothers from the market’s shores, both stock prices and investor sentiment have been as capricious as the British weather. Since this defining and pivotal event the Chicago Board Options Exchange Volatility Index (the VIX or “fear index”) has become one of the most followed and highly publicised “barometers” of market turbulence.  And, as the number of complex derivative contracts on volatility mushroomed, the VIX, which generally moves in the opposite direction to equity markets, has been increasingly touted as the ultimate windcheater with which to protect one’s portfolio.
Source: Brewin Dolphin/Bloomberg
Indeed it may reflect the conviction in this view that over the last four months there have been enormous inflows into volatility trading strategies. To qualify this further, according to a research piece from Morgan Stanley, seven out of the top 10 fastest growing funds in alternative investments offered exposure to volatility.

Mathematically, volatility is simply a measure of the magnitude that stock prices have moved in the past, with a bigger number signifying greater moves. Given this price swing can just as easily be down as up, stocks with higher volatility are assumed to posses higher levels of risk. However, the Volatility Index does have some subtle but crucially different features.

The VIX was created in 1993 by Professor E. Whaley to provide a forward looking measure of volatility that investors are expecting to see in the equity markets (specifically the S&P 500 Index) in the short term. It tells us that, based on today’s reading of 17 “volatility points”, the S&P 500 index is expected to move over the next month by 17% on an annualised basis (which is a monthly move of just under 5%).

An important contributor in the calculation of this index is the cost of derivative contracts used to insure portfolios (known as ‘put options’). And, as the market mood swings from smug confidence to neurotic anxiety, the VIX will faithfully reflect this by moving higher. Indeed the speed with which the VIX moves will often reflect the perceived severity of a crisis, rising sharply or ‘spiking’ at times of acute market turmoil – hence the VIX’s fearful nickname.

It is a similar theory in any insurance company’s pricing model; think what would happen to home insurance premiums in areas which the Environment Agency dictates are at risk of flooding. The same applies to the financial world.

The chart below highlights the unsettling events which drove the index to leap up at various times over the last 20 years.
Source: Brewin Dolphin/Bloomberg
So, given the behaviourally opposed pricing moves (to equity markets), investments based upon the VIX index have been considered extremely attractive of late. However, we would suggest investors consider the infamous words of Franklin D Roosevelt, delivered in his inaugural address, “let me assert my firm belief that the only thing we have to fear is fear itself”. In that respect, we have observed that using ‘the fear index’ as one’s sole insurance policy might not always be sufficiently rewarding…but more on this in my next blog.

Shakhista Mukhamedova
Investment Analyst

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