Pipe Down and Enjoy the Calm

Investors are hard to please. They wail and moan when markets are volatile. And when markets are quiet, well, they complain about that, too.

Not me. I say that the recent calm in markets is pure bliss. The CBOE Volatility Index — the widely followed gauge of U.S. stock market volatility better known as the VIX — has averaged 19.5 since its inception in 1990. But so far this year, the VIX has averaged just 11.5. (The lower the VIX, the lower the volatility, and vice versa.)

Rather than be thankful, some investors fret that the low volatility portends some horrible misfortune. Others blame low volatility for their current troubles. Traditional active managers — as opposed to the robots running smart beta — complain that it’s impossible to beat the market when it’s this calm (as distinguished from all the other reasons why they fail to beat the market).

The latest complaints come from commodity trading advisers. CTAs try to profit from price trends in stocks, bonds, currencies and commodities by using futures contracts, betting on assets that have increased in value recently and against those that have declined.

It’s easy to see why CTAs are upset. The BarclayHedge US Managed Futures Industry BTOP50 Index — a collection of the largest trading advisers — is down 2.2 percent this year through May. That follows declines of 0.9 percent in 2015 and 4.4 percent in 2016.

What seems to be ailing managed futures? Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, says that “trend followers typically do well during periods of high volatility.” In other words, no volatility, no returns.

History doesn’t support that proposition, however. I examined the correlation between the rolling three-year annual returns of the Managed Futures Index and the rolling three-year average volatility of various assets underlying it.

In most cases, there’s no meaningful correlation. For example, the correlation between the Managed Futures Index and the VIX has been a negative 0.04 from December 1992 through May of this year. The index’s correlation with the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index, or the bond VIX, has been 0.04 since December 2005. The correlation with the CBOE Oil ETF VIX Index has been 0.22 since April 2010, and it’s been a negative 0.11 with the CBOE/CME FX Yen Volatility Index since December 2010.

To the extent that the Managed Futures Index is correlated with the volatility of any asset, that correlation is actually negative. The correlation between the index and the CBOE Gold ETF VIX Index, for example, has been a negative 0.42 since May 2011, and it’s been a negative 0.34 with the CBOE/CME FX Euro Volatility Index since December 2010. So, if anything, trend followers appear to fare better in periods of lower, not higher, volatility.

There’s another reason to suspect that low volatility isn’t the culprit for what’s ailing CTAs. Like managed futures, momentum is a strategy that relies on trend following. Yet despite the low volatility, the MSCI USA Momentum Index is up 18.1 percent this year through June, including dividends, handily beating the S&P 500’s return of 9.3 percent.

Also, the correlation between the rolling three-year annual returns of the Momentum Index and the VIX’s rolling three-year average has been a negative 0.41 from June 1997 through June of this year. That negative correlation implies that low volatility helps rather than harms trend following.

Raman Subramanian, head of equity applied research for Americas at MSCI, isn’t surprised. He noted in an email: “Harvesting momentum when volatility is high can be challenging. High volatility can make a momentum strategy vulnerable to sharp declines during market turmoil.”

There are some caveats to the data. For one thing, CTAs trade globally, whereas many of the volatility indexes cover only the U.S., so there isn’t perfect overlap between the Managed Futures Index and the volatility indexes. Also, the volatility indexes only go back a decade or two, so the numbers are somewhat limited.

Still, the available evidence suggests that low volatility is no enemy of managed futures. Maybe trading advisers — and everyone else for that matter — should stop carping about low volatility and start enjoying the quiet. They’ll miss it when it’s gone.

Source: Bloomberg Gadfly, https://bloom.bg/2y39HDH