Ask one of the creators of the VIX (volatility index) what the indicator is, and you might get a convoluted answer. Something like, “The VIX is the market’s expectation of 30-day volatility and is constructed using the implied volatilities of a wide variety of put and call options on the S&P 500 index.” OK, whatever.
Investors will recall that 2017 was one of the most tranquil investment environments in memory. By mid-2017, the VIX, often called the “fear gauge,” was signaling a nearly complete absence of fear in the stock market, falling to its lowest level since 1993.
During this period, traders (or perhaps gamblers is a better term) were placing bets to capitalize on this lack of risk. As Wall Street is prone to do, investment bankers had concocted an estimated $200 billion worth of “volatility control” funds and products using the VIX. This allowed the traders to “short” volatility by investing in inverse-VIX exchange-traded products.
It was a very profitable trade until early February, when the fear gauge spiked, causing a severe reaction in these arcane investment vehicles tied to the VIX. A hedge fund in Chicago with $500 million in assets that was shorting volatility lost 82 percent in a matter of days, whereas a fund in Denver that had bet on volatility increasing recorded an 8,600 percent profit.
One of the collaborators who invented the VIX, Devesh Shah, commented, “Everybody knew this was a huge problem. All these inverse-leveraged products at the end of the day cost people a lot of money. In my wildest imagination, I don’t know why these products exist. Who do they benefit? No one, except if someone wants to gamble.”
As opposed to gambling, there has been a lot of effort poured into developing investment strategies that reduce volatility. Institutions have employed strategies like “risk parity,” attempting to reduce volatility by investing across uncorrelated asset classes. Yet risk parity’s performance track record has been unimpressive.
Many individual investors have a hard time with volatility. When the monthly statement arrives, and the portfolio value is less than the prior month, a feeling of loss overcomes—even though, unless you sell, no loss is realized. Oddly enough, some investors would prefer an investment that delivers a smooth 6 percent annualized rate of return, rather than a lumpy 10 percent return.
The error being made here is to confuse volatility with risk. Risk in investing implies the chance of losing money. Much of Wall Street and academia get this wrong by instead equating volatility with risk. Just because volatility increases in the stock market doesn’t mean you will lose money or that your investments are riskier. In fact, volatility can spell opportunity by allowing a profitable sale when prices spike higher and creating bargain purchases when prices sink lower.
Successful investors recognize that the public markets exist to serve them, not to guide them. This is the idea behind Ben Graham’s Mr. Market allegory (Chapter 8 of “The Intelligent Investor”). A steady temperament grounded in patience and rational long-term thinking is the formula for success.
Most of the time, an investor should pay little attention to the daily gyrations in the stock market. However, when market volatility serves up a fastball down the middle, he should be ready to swing.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or firstname.lastname@example.org.