Institutional investors are increasingly questioning whether the fear index, a reflection of volatility, is still a reliable indicator of market risk.

Everyone loves a nice, round, easy-to-understand number that reduces a complex investing environment to something safe and comforting. This explains why the media adores the Chicago Board Options Exchange Volatility Index (VIX), more commonly known as the fear index.

But there are growing concerns the VIX could be lulling investors into a false sense of security by hiding risks building up below the surface.

This was discussed in depth at the recent Investment Magazine Fiduciary Investors Symposium, held in Healesville, Victoria, November 13-15, 2017.

LUCRF chief investment officer Leigh Gavin facilitated a panel discussion titled ‘Vanishing Markets: Is the fear index obscuring systemic risk?’ Gavin set the scene by noting that investors are experiencing an “enormously benign market for volatility in an environment of huge political and social volatility”.

The passive factor

The fear index was launched in 1993. Since then, it has closed below 10 only 38 times – and 34 of those were in 2017. Values below 20 are associated with lower levels of volatility.

Gavin posed the question: “How does the VIX behave when we invariably, inevitably, move into an environment of higher – or at least more normal – volatility?”

QIC director, research and strategy, Katrina King, said she is concerned that the VIX is not reflecting risks stemming from the global trend towards passive investment strategies.

“Now we have over 50 per cent of US equity mutual funds being managed passively, whereas in the 1990s it was 90 per cent managed actively,” King said. “Your active buyers will tend to suppress volatility over the longer timeframe because they’re the ones who can assess value and buy at what they think is a cheap price, and sell at a high price. But if we’ve got fewer of those active players in the market in the next crisis, it does concern me that volatility self-perpetuates.”

Volatility just one factor

CFM head of Asia-Pacific Steve Shepherd said it was important not to oversimplify the relationship between volatility and risk.

“Volatility is one measure of risk but certainly not the only measure,” Shepherd said. “It is an excellent proxy for many, many things – as long as you recognise it is just a proxy.

“If you’re really managing risk, you do need to think about what different risks you need to look at, what kinds of stress tests need to be applied to different asset classes, different strategies; where is volatility a succinct measure that is coherent.”

Shepherd described what could happen if risk isn’t managed: “Volatility is a risk premium, which means when it goes up, it goes up more violently than it goes down. If you’re short that, then you’ll get hurt.”

Gavin described current global market conditions as “full of abundant liquidity” and “also full of low volatility”, two trends “we know will turn”.

King noted that research on the global financial crisis (GFC) concluded it wasn’t a true credit crisis but a liquidity crisis.

“The liquidity premia certainly blew out in that time period,” she said. “To safeguard against a future liquidity crisis, QIC is making sure it has the tools and the modelling to break apart liquidity and credit risk during the next sell off. And hopefully be able to quell fears and reduce the risk of forced selling.”

Shepherd said the changing nature of volatility probably did not represent a paradigm shift.

“We shouldn’t fool ourselves into thinking we’re special and living through very unique times,” he said. “We’re living through times that are, I suppose, unique in one sense. But assets go up and assets go down; and volatility goes up and volatility goes down.”