Volatility On Holiday

One day volatility will return to the financial markets. When that day arrives (and why) is anyone’s guess. Meantime, vol remains in remission across the major asset classes, based on a set of proxy ETFs.

When the usual routine revives, the change in the financial weather is expected to resonate early on in our Global Managed Volatility Strategy (G.B16.MVOL). At the moment, however, the market landscape is calm – unusually calm.

Indeed, for all 16 funds in G.B16.MVOL a risk-on signal applies across the board. For this particular strategic flavor that’s a reflection of smooth risk risk waters. How are we defining risk in this context? Let’s answer with a brief tour of the strategy’s basic rules.

The basic assumption that drives G.B16.MVOL is that when volatility spikes that’s a warning that the trend may turn rocky ahead. Nothing new there – a deep pool of research tells us that volatility cycles through time and relatively high vol in markets is often associated with low/negative returns and vice versa. The challenge is deciding when a low-vol environment is shifting to high vol. As always, ignoring the noise is difficult in the interim.

G.B16.MVOL attempts to separate the signal from the noise as follows. First, calculate volatility (annualized standard deviation of daily returns) over a rolling 10-day period. Next, monitor the 10-day vol over a rolling 100-day window. Whenever it jumps above the 99th percentile for that 100-day period it’s time for risk-off. Otherwise, anything at or below the 99th percentile is risk-on.

How has that worked out? Not surprisingly, perfection remains elusive. But overall, on a portfolio-wide level, the wins have enjoyed a modest edge over the losses and generated a handsome result for the strategy vs. the benchmarks.

As for current conditions, it’s notable that all the 16 funds in G.B16.MVOL remain in a risk-on posture at the end of trading on Sep. 2. You have to go back to Mar. 27 to find a fund in a risk-off position -- VanEck Vectors International High Yield Bond ETF (IHY) was the lone outlier at the time.

Here are the funds and the target weights (which serve as rebalancing bull’s eyes for the portfolio at the end of each calendar year). Otherwise, each ETF is managed in its own bucket, so to speak, so that it’s either risk-on or risk-off. When the latter, the risk asset is moved to a cash proxy: iShares Short Treasury Bond (SHV).

Typically, some portion of G.B16.MVOL’s funds is in a risk-off position. The list of the ETF assets that are shifted to cash evolves, but it’s rare that everything is risk-on or risk-off. As it happens, now is one of those times.

This too shall pass, for good or ill, but at the moment you can hear a pin drop from a volatility perspective. What might trigger a regime shift? So many possible answers, so little time.

But here at The ETF Portfolio Strategist we’re comfortable to let risk rise via G.B16.MVOL and let nature (and risk management) take its course. On that note, here’s how G.B16.MVOL stacks up at the moment (through today’s close, Sep. 2) relative to our usual portfolio benchmarks and our other two proprietary strategies. (For definitions of all the portfolios and risk metrics referenced in this article see this summary.)