Equity index volatility, whether realised or options-implied (tracked by indices such as the VIX), has been persistently low over the past year. The VIX, for example, averaged about 12.1 in the past year, an annual average that has not been seen since its creation in 1993. Similarly, realised volatility for the MSCI World Index has not averaged at its current low levels since 1979.
‘Investor complacency’ is the common interpretation of sustained low volatility. In this case, equity investors are perceived to be overly optimistic in the face of geopolitical, growth and policy risks. Moreover, with the financial system awash with liquidity and expensive, low-yielding bonds, there is ‘no alternative’ to equities, propping up prices and ‘putting a floor under’ volatile market dips.
On the surface then, supressed volatility may reflect a mispricing of risk, which ought to dent expected returns. It is also bad news for actively managed portfolios, because it implies less scope for differentiated returns from stocks.
However, today’s low index volatility masks two important underlying trends that actually suggest the opposite — an environment where active management ought to thrive. First, on average, individual stock volatility has actually risen over the past few years, not fallen. Second, stocks are currently less correlated to one another than at any time in the past 15 years (see chart below, which averages all correlations across stocks in the US).
Those two trends suggest that recent low index volatility is a direct result of more diversification of risk within the index, and not because of record-low stock volatility across the board. In other words, investors have been more discerning at the company level, rather than complacent at the wholesale level. More aggressive rotation between stocks, sectors and styles may also be behind lower average correlations.
How does this impact on portfolio construction? Lower index volatility can lead to higher Sharpe ratios for managers that rely on equity beta. At the same time, less correlation between stocks presents significant opportunities for managers that seek security-specific alpha. Multi-asset portfolios can take advantage of both patterns by combining directional market strategies alongside more concentrated stock portfolios. A good mixture of the two styles ought to be beneficial for portfolio returns as well as risk.
Sizing of active bets is also affected. Because correlation between stocks is generally lower, the same portfolio risk can be achieved with less aggressive positioning, all else equal. Alternatively, unchanged sizing of active bets may result in lower portfolio volatility, all else equal.
What might derail this benign correlation environment? Correlations across stocks tend to rise during bear markets and crises. Other than that, events that can have far-reaching consequences — for example, Brexit or the US election — have tended to cause temporary correlation spikes in more recent times.
Average correlation across US stocks