Does Volatility Mean Opportunity?

Periods of great uncertainties similar to the one we are currently experiencing due to Covid-19 are relatively rare but do in fact occur more frequently than may be thought. In the financial markets, regardless of the cause, whether endogenous as in 2008 during the financial crisis or exogenous as in 2020, heightened uncertainty translates into a large array of investor behavior.

Traditional expansion phases in the economy can generally be characterised not only by increased economic output and relatively predictable evolutions in corporates’ earnings, but also by relatively traditional financial analysis of an issuer, coalescing around market consensus.

However, during a crisis phase, the intrinsic disruption brings into play a wider array of opportunities for investors. The ensuing pattern of purchase or selling of assets on the market can accentuate the crisis. For many investors, the pattern of the crisis is thus characterised by this acceleration of market volatility.

Over the past 40 years, as derivatives markets have grown in volume, the concept of implied volatility of options has become central to the measure of uncertainty for market participants. Based on this, the Chicago Board Options Exchange has been publishing an index, the Volatility Index (VIX) since 1986. This “index of options” illustrates the intrinsic fears of equity market operators on a scale ranging from 0 to 100 (maximum fear).

Since its inception in 1986, the VIX index has mostly coalesced in a range between 10 and 30, and has only surpassed 40 during certain major bear markets that have defined the past 35 years:

-          Market crash of October 1987

-          Russian financial crisis of October 1998

-          9-11 attacks in September 2001

-          Enron scandal in July 2002

-          Financial crisis in October 2008

-          Covid-19 crisis in March 2020

Each of these spikes indicated that market operators had significant doubt about where the economy would land afterwards, and this uncertainty is reflected in the index.

Over the life of the index, the index peaked above 82 – its historical highest - on March 16, 2020, which compared to the previous high of 80.86 at the height of the global financial crisis in 2008. This indicator highlights the exceptional sense of fear and doubt that has taken over the market since March 2020 in one of the largest societal and economic shocks in decades.

With a swift response from all the central banks and governments supporting the economy and injecting liquidity to shore up the financial system, volatility has decreased since its peak but has remained in a range between 25 and 40, well above its historical average.

This level indicates market operators are still doubtful about the future and perceive significant risks. When the real economic and social impact of the Covid-19 crisis is known, the index could potentially come back closer to its long-term average which would indicate a stabilisation of the markets and of market actors’ behaviors.

In the context of wealth management, market uncertainty is naturally raising questions for wealthy families and entrepreneurs. Most of these investors tend to have a long-term approach allowing them to keep a more serene perspective. Over the long-term, downturns happen regularly and cannot be avoided.

A strategy to counter downturns is by balancing and diversifying portfolios of investments across asset classes and uncorrelated assets. However, during periods of higher volatility, option-based products can deliver asymmetric return patterns (with commensurate risk).

As Highlighted in BNP Paribas Wealth Management’s 2020 Investment Themes Post Covid-19, putting together a consistently diversified investment strategy mixing varieties of assets and underlying risks can help investors ensure a consistent return over the long term.

Even though the VIX index demonstrates, the crisis is not over, investors can access the financial strategies to manage their wealth based on their appetite for risk in these historic market conditions.