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Portfolio protection from volatility rebirth

Market gyrations in February marked a rebirth of share market volatility. After an historically unprecedented period of low or ‘episodic’ volatility, SMSFs now need to be prepared for the new market environment.

Despite a widely held view to be contrary, until recently the past few years have not been a particularly volatile time for global share markets. In fact, the VIX Index – which is a measure of expected volatility on the S&P 500 Index over the next 30 days – shows the period between 2015 and 2017 was one of the most non-volatile periods in the market’s history and market volatility was in fact at 100-year lows.

But investors suffer from recency bias and media headlines every time markets jump up or down do not help. While there have been volatility spikes – market movements on the back of unexpected developments, such as Brexit or Trump, over the past few years – there has not been an ongoing period of volatility in the market beyond spikes of a few hours or at most a few days.

But 2018 has so far shaped up to be very different, prompting some commentators to observe that we are seeing a return to the ‘old normal’. Last year was the first year in the history of United States stocks where there was not a single negative return month for the S&P 500, but market volatility made a powerful, if short-lived, resurgence in early 2018.

Volatility is likely to sustainably rise in the foreseeable future. With asset prices increasing, labour markets tightening in the US, quantitative easing unwinding, the European Central Bank slowing down and oil in the mid-$60 range, we are starting to see shoots of growth and inflation will likely not be far behind.

SMSF investors have many reasons to be cautious. Global equities have had an outstanding run – especially in US equities – and it would be prudent for investors to think about portfolio protection to insulate their portfolios in the event that something untoward happens. The probability of that has unmistakably risen.

Another consideration – although it may seem counter-intuitive – is that volatility is not necessarily bad for SMSF portfolios and can in fact enhance portfolio returns.

Most investors see volatility as simply a measure of risk. But it is also an asset class in its own right and one that offers investors portfolio returns that are largely uncorrelated to equities. When equity markets fall, volatility tends to rise, and vice versa.

An investment in volatility can be be accessed through the VIX Index with the use of options and volatility derivatives. This has, in fact, been one of the fastest-growing option markets in recent years.

Investing in options on the VIX Index allows investors to access this negative correlation, which cannot be as reliably harnessed in other asset classes. What’s more, VIX options now rank with the world’s most liquid and have been known to trade over 1 million options contracts a day.

While there is no question market volatility and falling share prices can be bad for long-only investors over the short term, volatility as an asset class is a different matter.

The average SMSF is long on shares and not many short the market. Market volatility creates opportunities for investors who short the market and who make a call on which shares will fall in value, as well as which shares will increase.

With the advent of VIX futures options and exchange-traded products (ETP), high volatility does not necessarily mean a negative return for investors.

VIX today is front and centre of the conversation in major markets around the world and volatility options are in fact driving investors into the market. Interestingly, it is retail use of these products – particularly ETPs – that has driven this growth.

For instance, the most popular ETP in the US and one of the top five most liquidly traded securities is the VXX, which is a VIX options-based product.

In this environment, SMSFs would be well placed to position their portfolios – using options over the VIX – to prepare for the market volatility ahead.

This strategy means investors can put some negatively correlated assets into their portfolio, which will help them profit from periods when markets turn down and volatility rises.

Generally speaking, people want to own equities because over the long run they do well. Allocating a portion of the portfolio to a volatility strategy can help to mitigate or circumvent the losses that come when markets go down.

Adding a volatility element to an investment portfolio is not new. A number of institutional superannuation funds have adopted a volatility overlay approach to protect equity investments from market movements and to enhance investor returns during market downturns.

SMSFs can also follow their lead and invest in volatility, either directly – by adopting a volatility-focused strategy to capture alpha from highly liquid exchange-traded VIX options – or through a managed fund that can achieve this outcome for them.

With volatile markets set to continue to challenge SMSF investors, investing in volatility can fill an important gap in many funds’ strategies – that of real and sustained portfolio diversification.

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