Wednesday, 28 September 2016

The onset of the northern summer normally means a quiet period for global share markets, as traders and money managers in the US and Europe take time out with their families and head off on holiday. Trading desks are vacated and decisions are deferred as people recharge. But this year July and August were especially quiet, even by past standards. This post peeks behind the curtains to look at why things have been so quiet, and what this could mean for QSuper portfolio1 returns.

Investment risk is normally measured in terms of ‘volatility’. Statistically, volatility refers to some measure of deviation from an average level; as market prices move up and down volatility rises, and as markets move less volatility falls. Measuring past changes in prices around average levels is one way to assess volatility, while another is to look at market expectations for forward volatility. The chart in Figure 1 shows the Chicago Board of Exchange’s Volatility Index (VIX) since the beginning of the year. This index is a forward-looking measure of risk and captures trader’s expectations regarding US equity market volatility over the coming period. As can be seen, after spikes in risk at the start of the year and during the Brexit referendum, expectations of market volatility quickly declined to very low levels over July, and stayed there during August. As mentioned, these levels were far below ‘normal’ levels for these months. The chart in Figure 2 shows the average level of the VIX index for each month of the year since 2001 (blue bars), with the average level for the VIX index over July and August in 2016 shown as red dots. July and August were quiet, very quiet.

Figure 1: CBOE Vix Index

Figure 1_CBOE Vix Index 

Figure 2: Average Monthly CBOE Vix Level, 2001 to 2016

Figure 2_Average Monthly CBOE Vix Level_2001 to 2016

As investment managers, we get worried when things are quiet. Risk has a habit of spiking when you least expect it and we saw that again in September this year, with equity markets whipsawing and the VIX Index jumping. While not yet ‘normal’, it does feel that these periods of quiet, followed by excessive spikes in volatility, are becoming more the norm than the exception these days. In short, global equity markets have become more ‘fragile’.

Market fragility can best be described as the ability of markets to respond to an unexpected shock or announcement. If a market is being driven by a large number of influences, a shock to a single one of those drivers should make relatively little difference to the market level, and we describe that market as robust. However when markets are being driven by a very small number of influences, a shock to one of those influences can have a shattering effect on the market level. We refer to these market states as fragile.

We can assess market fragility using quantitative techniques. The chart in Figure 3 shows our estimate of how market fragility has increased since the start of 2013. We believe it is no coincidence that the rise in fragility has corresponded with increased speculation as to the future direction of US interest rates - as the influence of policies such as quantitative easing by central banks around the world has grown, equity markets have concentrated their focus on fewer and fewer drivers, making them more fragile.

Figure 3: QSuper Fragility Index

Figure 3_QSuper Fragility Index

This fragility is dangerous. It essentially implies that a single influence is dominating market returns. When that influence is benign, markets are quiet, and when it is not benign, there is nowhere to hide. This is what we saw over July and August – after digesting the Brexit issue in June markets resumed their ‘Fed-Watch’. With few updates regarding US interest rates the markets were quiet, but Janet Yellen’s (the Chairman of the US Federal Reserve) speech in early-September immediately injected volatility back into equity markets.

At QSuper we constantly seek to diversify the influences that act on ‘our portfolio’ returns. We are averse to market fragility, and focus our efforts on making our portfolios robust to different outcomes. The increase in equity market fragility over recent years has coincided with a strategic shift by QSuper away from equity-market risk in the QSuper portfolios we manage. This, in turn, has served to produce what we consider to be more reliable and robust investment returns for our members over this period. Going forward we will continue to seek diversity in our investments with the objective of producing reliable and strong risk-adjusted returns for members.

1. The term ‘QSuper portfolio’ or ‘our portfolio’ is used to refer collectively to the underlying portfolios of assets which in combination make up the individual asset allocations of the QSuper Lifetime and the Balanced, Moderate and Aggressive investment options.

The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and you should get professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.

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