By Doug Kramer, Co-Head of Quantitative & Multi-Asset Class Investments, Hakan Kaya, PhD, Portfolio Manager, Risk Parity
Our volatility models indicate that a return to the low-vol of 2017 is highly unlikely.
With investor psychology recently swinging from fourth-quarter despair to New-Year optimism, we wanted to highlight that, despite the market recently moving higher, we believe that the higher volatility we became used to in 2018 is here to stay. In fact, our models currently suggest that the chance of a return to materially lower volatility - 11-12% or less - is very low over the next few years.
At Neuberger Berman, we utilize a volatility forecasting methodology as part of our risk parity strategies to help us more accurately balance risks across asset classes rather than using backward-looking measures or a simple market-based measure such as the CBOE Volatility Index (VIX).
In this edition of Systematically Speaking, we isolate a few key components of the S&P 500 volatility forecasting module from our risk parity strategy and show that, despite the fact that realized volatility and the VIX are now higher and intuitively present more downside risk than they did a year ago, our forecasting module suggests that volatility will remain relatively high. Moreover, our forecasting module puts the probability of a return to the sub-10% levels of 2017 outside the 90th percentile.
Our Model Indicates Many More Years of Elevated Volatility
NB model inferred S&P 500 Index volatility versus a market-based measure of volatility and realized volatility
Source: Bloomberg, Neuberger Berman. Forecasts may not materialize. Projections or other forward-looking statements regarding future events, targets or expectations are only current as of the date indicated. There is no assurance that such events or projections will occur, and may be significantly different than that shown here. See Additional Disclosures at the end of this material, which are an important part of this presentation.
Our modelling stems from the idea of "volatility clustering," which is a fancy way of saying that large changes in prices tend to be followed by large changes, and small changes in prices tend to be followed by small changes. This may not be foreign language to fundamental investors, who would call this sort of behavior "herding": market participants tend to do things similarly in the short run, while reverting back to the mean in the long run. As a result, the short run in financial markets is often characterized by all sorts of feedback loops that aggravate the magnitude of changes in either direction, making volatility predictable.
How predictable? The chart above shows the descriptive power of our model. The solid dark blue line shows how our model assessed the current level of volatility, between 2006 and 2018. You can see that it has closely followed the light blue line, which shows the realized volatility that we were able to observe, empirically and with hindsight, using a 52-week window and given a 26-week lead in the chart. The gray background shows the VIX level, derived from the prices of options maturing in one month's time: you can see that this is a much less reliable description of current S&P 500 volatility than our model, due to the premia that traders price into options and other noise that makes its way into these markets.
Given that our model has been successful historically in describing current volatility, it is interesting to use it to forecast future volatility.
To contrast our current view with a view from the past, we drew our volatility forecast at the end of 2017 (the gray dashed line), which was a time when the VIX had averaged approximately 10% for the 12 months and the realized, rolling 52-week volatility was 6.5%. That low-volatility environment was associated with the S&P 500's winning streak of 12 consecutive months.
Back then, our model forecast a steady rise toward 14-15% volatility - basically, persistence of the low-volatility of 2017 with some mean reversion higher. Today, our model is forecasting volatility to persist around the current, higher levels, and to do so for at least the next two to three years (the blue dashed line). That is the "volatility clustering" effect in action.
In short, our model suggests that the recent return to more optimistic investor sentiment is unlikely to signal a return to materially lower market volatility. Based on our model, we believe that volatility is here to stay, and that asset allocators should monitor and manage portfolio risks accordingly.
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity and industry group representation. It is a market value-weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value. The S&P 500 Index is one of the most widely used benchmarks of U.S. equity performance.
The CBOE S&P 500 Volatility Index® (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility. Several investors expressed interest in trading instruments related to the market's expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006.
Forecasts may not materialize. The volatility estimates contained herein are being shown to illustrate the team's investment decision-making process and are not intended to provide any predictions or guarantees or assurance about the future volatility of any security, asset class or portfolio. Projections or other forward-looking statements regarding future events, targets or expectations are only current as of the date indicated. There is no assurance that such events or projections will occur, and may be significantly different than that shown here. The information contained herein, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Sector views should not be construed as research or investment advice and do not constitute a recommendation to buy, sell or hold securities in any sector.
This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Neuberger Berman is not providing this material in a fiduciary capacity and has a financial interest in the sale of its products and services. Investment decisions and the appropriateness of this material should be made based on an investor's individual objectives and circumstances and in consultation with his or her advisors.
This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. The firm, its employees and advisory accounts may hold positions of any companies discussed. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types.
Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
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