If you’d asked me about “volatility” when I went through business school 40 years ago (I specialized in finance), I would’ve replied with nothing but a quizzical stare.
Beta, the first measure of volatility, was only just beginning to be used. In those days, the simple-minded view was that high-beta stocks just tracked the market, though they zoomed up and down several times as much.
For us wannabe gunslingers, it followed that the way to make money was to find the highest-beta stock you could and ride it to glory in the next stock market boom.
Needless to say, that didn’t work.
Some stocks were highly correlated with the market and thus had betas close to “1” – but others weren’t, and they had high or low betas because their prices zoomed up and down independent of the market or didn’t move much at all.
Mining stocks, which have sunk continually in price since 2011 while the market has soared, are a current example.
Today, therefore, we use “volatility” – technically the normalized standard deviation of daily returns – as a measure of the variability of individual stocks and the market as a whole.
For its part, the Chicago Board Options Exchange Volatility Index (VIX) has remained at elevated levels (above 20, compared to its usual level in the low teens) for most of the last three months.
Of course, this matters very little to individual investors buying for long-term investment.
However, it’s important to institutions, which are imbued with the theories of modern finance. And that, in turn, can be useful to income investors.
By understanding institutional behavior, individual investors can improve their own returns without following the herd.
Today, institutional investors follow the precepts of modern financial theory, which suggests that you set an acceptable level of risk then vary your holdings between stocks, bonds, commodities, hedge funds, and other asset classes, using leverage if you like.
That works fine until the risk parameters of a particular asset class change significantly.
In this case, with the VIX high for a prolonged period, equities seem riskier than they did not long ago. By the tenets of modern financial theory, institutions should sell shares and redeploy the money into other investments (or simply repay debt if they have any).
Indeed, such actions likely contributed to the recent global stock market declines.
Chinese turbulence probably caused U.S. and European institutions to deploy their money away from Asia, causing outsized weakness in Asian markets – the iShares MSCI Pacific ex-Japan Index (EPP) was down 18% this year as of September 30.
Where Do We Go From Here?
For income investors, there are two ways to play this heightened volatility.
One is to assume that the recent increase in volatility will continue (despite a marked drop in the VIX over the last two weeks or so) and will cause institutional investors to reallocate more of their money from shares into other investments.
In that case, you should front-run the institutions, assuming a massive weight of money will follow you.
The principal beneficiary of such a reallocation would presumably be bonds, since returns on cash are negligible.
However, this doesn’t include high-yield bonds, since their returns are highly correlated with equities. High-grade corporate bonds offer a reasonable yield, and their yield premium above Treasuries has increased recently.
One option here is the SPDR Barclays Long-Term Corporate Bond ETF (LWC). This is a $218-million fund that invests in bonds rated BBB or better. It currently yields 4.58%, with a tiny 0.14% expense ratio.
On the other hand, if you believe that the recent drop in the VIX means volatility has calmed and October’s strength in the markets is here to stay, then consider buying into the sector that’s been beaten down the most.
After all, this will be the sector with the greatest chance of regeneration – though I wouldn’t advocate buying Russia or Brazil, both of which are poorly managed countries.
Conversely, Asian equities are now trading at 1998 levels, in terms of assets, and the underlying companies are much stronger than they were 17 years ago.
Though Asian shares only pay modest dividends, the Matthews Asian Growth & Income Investor (MACSX), a $3.3-billion fund that has been in business since 1994, yields 2.43% at present.
It’s part of the Matthews Group, an Asian specialist with an excellent track record. MACSX has handily outperformed the iShares MSCI AC Asia ex Japan Index (AAXJ), though it has a somewhat high annual expense ratio of 1.1%.
Bottom line: For those who believe the institutions’ flight to quality has been irrational, MACSX looks to be a good haven.
However, over the longer term, I think U.S. monetary policy will ensure that volatility returns, which may make LWC a better bet.