Regime Change: Volatility Returns in 2018
By Eric Metz
Regardless of where you sit, 2018 has kept you on your toes reinforcing the facts that equity risk is apparent, interest rates do move, and volatility has reinserted itself across global markets in a variety of asset classes. January continued the bull market of 2017, posting a -7.5% S&P return. February gave us our first shock, registering a 10% market drop and 176% increase in the VIX*, the largest percentage move in that amount of time in its history. The recovery that followed in March calmed most market participants, returning them to a high level of complacency while the Fed stayed its course. This renewed optimism peaked in September and was followed by another substantial retracement in October/ November as rising interest rates and the prospects of a sustained tariff war spooked investors.
Investors have become increasingly concerned as volatility resurfaced from an almost non-existent state. It drives home the fundamental point that advisors and investors must understand that risk management is the first step to prudent portfolio construction.
Unfortunately, there are few tools for keeping the portfolio intact, funding shortfalls, optimizing for taxes, and smoothing the ride while preserving returns. However, market savvy professionals have driven a material uptick in the usage of option-based strategies in risk-oriented portfolio construction, as evidenced by the 2018 OCC volume and the recent Greenwich Associates study.
A 2018 Example:
It's January 1st, 2018 and you own equities (S&P 500). Year-to-date you have experienced the following path*, and the emotions that accompany it. Now contrast that with BXM**, ***Long S&P & Short Dec 31, 2018 5% OTM Call on Jan 1, 2018.
The only difference between them is a risk managed option strategy on top of the equity exposure (S&P 500 is underlying in both).
Now it's November 30th and you want to invest in equities for the next 12 to 24 months. If either the blue or gray line are more appealing than the orange, then you have elected an option-based strategy rather than long-only equity. The ability for options to shape a return distribution ahead of time, lower the volatility, and give the investor additional peace of mind around potential outcomes are all compelling reasons to add an option element to your equity exposure.
Following the great financial crisis, equity markets enjoyed one of the longest bull runs in history against a backdrop of near zero interest rates and low volatility. Where the equity markets go from here, time will tell, however we have a key takeaway from 2018: Volatility has once again reared its head, and given its historically mean reverting nature, the regime may be shifting back towards longer term norms. Managing volatility and risk is both art and science and will be pivotal in navigating this new regime. The introduction of options strategies can provide one of the most cost effective and tax efficient means of meeting investors' goals. ■
Eric Metz, CFA, is the President and CIO of SpiderRock Advisors.
See disclosures here.