Short volatility
15 Apr, 2024

Aadil Omar, Head of Equity Research, M&G Investments

 

 

If there were a trifecta of features desirable to investors, it would likely include steady, linear, and above-average returns. These attributes seem like obvious choices, but when prioritised at the expense of underlying realities, they can lead to disastrous outcomes.

 

The pursuit of better-than-average long-term performance is not in question. Rather, it is the desire to achieve this without volatility, or worse, the suppression of volatility to create the illusion of steady returns, that can lead investors down a perilous path.

 

Pennies in front of a steam roller

 

The term “short volatility” charterises strategies reliant on a tame, non-volatile return stream to meet investment objectives. But what does it mean to be short volatility?

 

Being short volatility essentially entails making a bet that the level of volatility (or the rate at which prices fluctuate) will remain subdued over time. This strategy can yield gains in stable market conditions, but it leaves investors vulnerable to substantial losses when volatility spikes. Hence the metaphor ‘picking up pennies in front of a steamroller’.

 

In pursuit of certainty

 

Being short volatility is not unusual, though – much of our lives are premised on the notion that life marches to the drumbeat of predictability. When you board an aircraft, go for a routine medical, or even when you get your hair cut – you’re betting that things will turn out more or less as they have in the past. Sometimes this is not the case, but for the most part, “normal” generally means within expectation.

 

Humans have always sought to tame uncertainty and volatility in their environment. From the early days of agricultural societies, where crop diversification mitigated the risks of famine, to the development of modern financial instruments that hedge against market fluctuations, civilisations have made significant strides in managing risk (reducing the likelihood of the unexpected). These advancements have enabled individuals and societies to undertake ventures that were previously deemed too risky, leading to greater prosperity and progress.

 

This “surprise control” can’t be as readily transferred to the domains of financial markets and investing, though. These are much too complex for us to expect the normal to prevail uninterrupted.

 

Contagion

 

A plane crash is a devastating event, not just because of the potential loss of human life but also because it is so rare. As a result, we almost never consider the scenario of all planes operated by a single carrier, for example, crashing at the same time. But this is not the case in financial markets or the economy – when we think about a bank failing, it is not uncommon to consider the possibility of other banks failing as a consequence or indeed, since 2008, the possibility of a financial crisis that may well spread across the globe.

 

Why are plane crashes discrete while bank failures are contagious?

 

Generally, the degree of interconnectedness in global finance and the economy leads to significant correlations across asset classes and markets, especially when conditions are abnormal.

 

You know it when it gets you

 

Unlike other subjective events that don’t have clearly defined parameters, risk is one of those concepts that doesn’t always make itself known through observation. Furthermore, sometimes you will only realise the risk was present after you have suffered the loss.

 

In depicting the risk inherent in a position or asset, a probability distribution has become the industry standard for framing that risk. While it is normally assumed that more risk should offer greater potential return, the relationship is not necessarily linear – nor is it certain. One way to navigate this is to overlay probability distributions along the risk/return continuum. A low risk/return asset has a narrower distribution of outcomes vis-à-vis a riskier asset which has a wider range of outcomes.

 

This more complete depiction of risk and return got me thinking about the possibility of the same asset or asset class shifting along this spectrum under different circumstances. For example, gold was an asset that demonstrated low volatility for the first half of the past decade, but then saw a step change in volatility during the Covid-induced market crash and has remained elevated since.

 

It strikes me that accepting a degree of volatility is a rite of investor passage in the pursuit of better-than-average returns, more so today than in the past. Managing expectations is probably the more effective endeavour, rather than attempting to suppress or bet against volatility.

 

 

ENDS

 

 

Author

@Aadil Omar
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