Volatility has been on the run! For a factor that typically has abysmal performance and a very negative premia over time, Volatility is turning out to be 2020’s comeback kid. For all of the managers who actively tilt their portfolios away from this factor or manage ‘low volatility’ products, this recent trend from the Volatility factor could really be throwing a wrench into things.
An Unexpected Resurgence
Volatility certainly deserves its reputation as a negative performer, since January 2007 its cumulative performance was just shy of -57%.
A key question is whether the drivers of Volatility’s run this time around are the same as they were in 2009? A look at its composition may help provide an answer.
Interestingly, the composition of the portfolio is different across all three periods. For the current period (blue), we can see that the portfolio is long Financials, Energy, and Health Care and short Communication Services, Information Technology, and Industrials. This implies that currently, Financials, Energy, and Health Care are high Volatility sectors, whereas Communication Services, Information Technology, and Industrials are low Volatility sectors.
Have Correlations Changed?
Another method for comparing the Volatility drivers today vs 2009 is to analyze correlations. In Omega Point, common ETFs are screened on-the-fly to highlight the ones which have the highest correlations with specified factors. In our case, we can use the correlations of ETFs vs the Volatility factor to tease out differences in the market environment today vs 2009.
A striking difference between the two periods is that the magnitude of correlations was much higher in 2009 compared to now. In 2009, the top ETFs all had correlations above 80%; however, today, the top ETFs barely break 60% correlation to the Volatility factor. This tells us that Volatility, or possibly even the broader market, is likely more diversified today than it was in 2009.
Where Does Volatility Go From Here?
One thing is for sure - we can add Volatility’s positive behavior to the list of unusual occurrences of 2020. Volatility is broken and this has left investors scrambling to reposition for this new normal. Will Volatility become the new shining star of the factor world? Or is this just a temporary dislocation that will revert once the chaos in the markets subside? Time will tell, but in this time of market turmoil and the hunt for alpha, perhaps this dislocation opens up a new opportunity for investors and product creators alike to capitalize on.
US & Global Market Summary
US Market: 8/17/20 - 8/21/20
Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)
Please don’t hesitate to reach out if you’d like to better understand your own portfolio’s relationship to Volatility or any other factors.