“Happiness is having a scratch for every itch.” – Ogden Nash, American Poet 1902-1971
With the U.S. implied volatility (VIX) reaching a new low, much has been published over the increased popularity to ‘short’ volatility. We commented on this back in June when the ProShares Short VIX Short-Term Futures ETF (SVXY) had just risen over 70% for the year. As of the time of this writing, SVXY has now returned just over 100%, making this the home run trade so far in 2017. Pretty soon, taxi drivers and hairdressers will be bragging about their short vol investment strategies.
Whether the extremely low volatility environment represents a rational reflection of the current macro and investment landscape remains to be seen as a number of potential headwinds are forming on the horizon, such as the regulatory crackdown on excess financial leverage in China and uncertainty over fiscal initiatives here in the U.S.
Yet given the extreme sentiment that ‘low vol’ is here to stay, one cannot help but observe that the market is serving up a big matzah ball to skeptics and naysayers, daring them to take a swing by going long volatility.
However, given the steepness of the VIX term structure (Figure 1), those swinging at the matzah ball need to connect on the first swing as the radioactive decay from the rolldown cost quickly eats into returns.
Figure 1 – The Steepness of the Term Structure Means Your Long-Vol Timing Needs to Be Spot On (Data as of 7/25/2017)
The market has a nasty habit of serving up itches just to make one scratch. When our advisor partners ask us the most difficult aspect of managing model portfolios, our typical response is “to do nothing,” meaning don’t trade the models in reaction to or in anticipation of some market event. It is as if we are Paul Atreides (from the movie Dune) being commanded not to pull our hand from the pain box even though we can feel the itching and the burning.
When we survey the current market landscape, the temptation is to de-risk the portfolios and wait out the inevitable tsunami that would unwind all the popular, retail and leveraged-risk parity trades that are betting on the next 3-6 months resembling the tranquility observed over the last six months.
Indeed, we are closely monitoring this situation for our recently launched liquid-alternatives risk-managed portfolio, but, like Atreides, we hope to pass the pain box test by remaining disciplined and adhering to our asset allocation positioning across our traditional model portfolios. Even within portfolios, there is the temptation to reduce ‘beta’ in equities or credit spreads in fixed income, or to shift all assets overseas in the face of a weakening U.S. dollar.
A Possible Catalyst
What could catalyze a broad risk sell-off (apart from any currency disruptions out of China) would likely come in the form of a broad economic slowdown (a somewhat realistic risk given the length of the current cycle), but not this year as Bloomberg consensus forecast is expecting 2.2% GDP growth for the U.S. and 1.7-1.9% for Europe and Japan.
These aren’t barn burning, inflation-inducing growth numbers but are enough to support the current credit cycle. Although global manufacturing sentiment appears to be topping off (Figure 2), business conditions remain strong, particularly out of Germany and Japan (Figure 3). And despite increasingly hawkish comments from global central banks, financial conditions remain relatively loose (Figure 4).
Figure 2 – Pause in Global Manufacturing?
Figure 3 – Business Sentiment Remains Strong in Europe and Japan
Figure 4 – Financial Conditions Remain Loose
Buying insurance when everyone is selling it feels like the top contrarian call for 2017, and the market’s siren call to go ‘long vol’ cries louder with each new low reached in the VIX. But as this year has demonstrated so far, low risk levels can drop even lower even as equity valuations advance higher and credit spreads narrow further. For now, market skeptics will need to endure the ‘pain’ as the cost of insurance (or being out of the market) eats into relative performance.
Happiness Comes from Not Scratching
As tempting as it is ‘do something’ given the current environment, the better course of action for long-term investors is to do nothing. As model managers, we are constantly assessing the market environment for the most attractive risk/reward positioning, but we are also long-term investors understanding that factor performance cycles through periods of outperformance and underperformance.
One current itch being served up by the market is to rotate one’s risk factor exposures in light of the current low volatility environment that has rewarded large cap growth and short volatility.
For instance, U.S. momentum, on the surface, looks pretty extended given its outperformance so far this year (Figure 5), even though it was the worst performing factor in 2016. Value and small cap have both struggled this year and remain out of favor given disappointments over an inflation-driven cyclical surge that has yet to manifest itself.
Figure 5 – US Momentum Runs Ahead of Everything Else in 2017
Yet, digging into momentum one finds that the current basket doesn’t look too extended from a valuation standpoint. According to iShares, MSCI USA Momentum ETF (MTUM) trades at 23x trailing EPS (as of 7/25/2017), not too far above the 22x multiple for the S&P 500 (IVV). This is partly due to the May 2017 rebalance where high-flyer stocks like FB, AMZN, and GOOGL dropped out of the basket due to their relative volatility to the market. So, maintaining exposure to momentum appears to make sense despite the strong YTD outperformance.
From a valuation standpoint, ‘low volatility’ looks interesting relative to its levels prior to the 2016 July Brexit vote but has shown to be more prone to interest rate swings versus the other factors. ‘Value’ looks even more attractive versus post-November election levels given its underperformance, but a meaningful economic slowdown could weigh on its near-term performance as would a back-up in credit spreads. Finally, according to MSCI,‘quality’ looks unattractive due to a combination of high relative valuation and what appears to be a peak in global profitability and rising corporate leverage (most ‘quality’ factors track return-on-equity which is influenced by leverage), but ‘quality’ would likely benefit from a risk-off environment.
Of course, one can always abandon smart beta and move to cap-weighted indices, but small caps have badly lagged large caps this year (Figure 6). Hence, from a factor standpoint, the best course of action appears to just stay on the current course, tempting as it might be to do something else.
Figure 6 – U.S. Small Caps Have Badly Lagged Large Caps in 2017
De-risking your portfolio, whether through asset allocation or risk factor positioning, may feel like the right thing to do, but those market itches won’t stop, and one will be tempted to scratch somewhere else if the first scratch didn’t bring relief. Even if the tsunami of risk-off selling appears to be on the horizon, one will only know after-the-fact, so it’s probably better to lean into the wave rather than try to avoid it. Diversification (whether at the asset class, geographic, or factor level) remains the best tool for investors as market imbalances eventually work themselves out.
At the time of this writing, 3D Asset Management did not hold positions in SVXY and did hold positions in MTUM and IVV. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as July 27, 2017 and are subject to change as influencing factors change.
More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing firstname.lastname@example.org or visiting 3D’s website at www.3dadvisor.com.
Disclosure: I am/we are long MTUM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: At the time of this writing, 3D Asset Management did not hold positions in SVXY and did hold positions in MTUM and IVV.