Today’s blog post is written by Withum Wealth Management’s Managing Principal, James Ferrare, CFA, CPA.
Many of our clients are undoubtedly familiar with beach clubs and the sound of a life guards’ whistle signaling dangerous water conditions. Well the market doesn’t sound a warning whistle allowing time for investors to return “safely to shore” when they should. On February 5th, 2018, many investors dabbling in exotic instruments would have appreciated any type of warning signal. On that day, the CBOE Volatility Index (the VIX), a measure of expected volatility in the market recorded its biggest one day percentage change ever, climbing 100% and causing sudden and significant losses for those on the opposite side of that trade.
So, what happens when market volatility, as measured by the VIX, increases 100% in a day…as we all found out together, plenty. If you were an investor in any of the inverse volatility products such as the XIV, (the VIX spelled backwards, how clever), you lost about 94% of your investment in one day. But we soon learned that was only half of the story.
From supposedly sophisticated hedge funds to all levels of investors, surprisingly including millennials and endowments such as Harvard University, we found many had become entangled in a seemingly “safe” paired trade: 1) betting against volatility; expecting to profit from markets remaining calm and 2) maintaining long exposure to the equity markets. In some cases, market participants were “selling” volatility and using the premiums received to help finance a call option and/or long exposure to the equity markets. As the first part of the paired investment was imploding, the other side—long the stock market—was starting to exhibit tremendous downside pressure.
In times of market turmoil selling tends to beget more selling, even absent any deterioration in stock market fundamentals (i.e. earnings and growth outlook— both demonstrating strength not seen in over a decade). This type of non-fundamental selling did however have real roots; distressed selling related to margin calls, the receipt of unwelcomed stock related to risky option investments and the collapse of inverse related funds. Moreover, the uncertainty as to how many investors were trapped in this trade and how entangled were these seemingly disparate trades helped create a riptide type effect sucking markets lower.
As we also found out in the current period of low bond returns many market participants were utilizing leverage to magnify their results. The low rate environment also encouraged pension funds to assume greater portfolio risk, whether they knew it or not, as they too ventured into more esoteric “risk-on” investments to help compensate for below average bond yields and high expected returns. Warren Buffett once said “you never know who is swimming naked until the tide goes out”. Well the tide went out and the picture wasn’t pretty.
Withum Wealth has always believed portfolio construction should emphasize high quality stocks, bonds, select index based investments and prudent diversification. Swinging for home run investments (which begs the basic question is volatility even an asset class?) unfortunately can lead to disappointing outcomes as many investors were reminded of in February. To paraphrase the legendary Warren Buffett, we serve as a client fiduciary and as such we prefer to hold on to our bathing suit.