Market Insights is a piece in which Kensington’s Portfolio Management team will share interesting and thought-provoking charts that we believe provide insight into markets and the current investment landscape.
Unpacking the Current State of Market Volatility
While investment returns are typically the primary focus for investors, market volatility (or lack thereof) has recently become a growing focal point. Historically, periods of high and low volatility have been indicative of underlying market dynamics and broader economic conditions. However, recent observations indicate an unusually depressed level of market volatility, particularly as measured by the VIX, often referred to as Wall Street's "fear gauge."
The Current State of the VIX
The VIX, which measures the market's expectation of volatility over the next 30 days, has been steadily declining for almost two years and now sits at historically low levels. The VIX closed at 11.93 last Friday (see chart below), the second-lowest level since November 2019, almost 40% below its long-term average of 19.5. This close ranks in the bottom 5th percentile in the VIX’s history, at a time when uncertainty around Fed action, inflation, and growth remains unresolved. This begs the question: Why is market volatility so subdued despite prevailing economic uncertainties?
Source: Trading View as of May 28, 2024
Factors Contributing to Depressed Volatility
Rise of Short-Term Options
One significant factor contributing to the depressed levels of the VIX is the rise in popularity of short-term options, often referred to as "0DTE" (zero days to expiration) options, a topic we covered in length in February 2023. Today, 0DTE options account for almost 50% of all S&P 500 option volume (chart below). According to a report by the Bank for International Settlements (BIS), the increased use of these short-term options has fundamentally altered the volatility landscape. These options allow traders to speculate on intraday moves without committing to longer-term positions, thereby reducing the overall demand for traditional options that influence the VIX.
Source: Bloomberg, BofA Global Research
Impact of Yield-Enhancing ETFs
Another potential contributor to lower VIX levels is the role of yield-enhancing ETFs that use options contracts to derive income. The BIS report highlights that these ETFs, designed to generate yield through strategies such as covered calls, have a suppressive effect on volatility. By systematically selling options, these ETFs contribute to lower implied volatility levels, thereby impacting the VIX. The rise of these vehicles, categorized under Derivative Income on Morningstar, has grown by over 300% since COVID (see chart below) as investors seek income not tied to the yield curve. The appetite for these investments is unlikely to subside anytime soon and may continue to weigh down overall VIX levels.
Source: Morningstar as of April 30, 2024
Market Sentiment
Of course, the “Fear Index” may be low simply because investors are not fearful. As we pointed out in our last Market Insights, the labor market is strong, earnings are expected to rise for the remainder of the year, and according to the most recent Consumer Confidence Index from the Conference Board, consumers are bullish on stocks. As of the May survey, 48.2% expected stock prices to increase over the next year, the third-highest reading in history (see chart below), trailing only March 2024 and January 2018.
Source: Charles Schwab, Bloomberg as of May 28, 2024
Historical Performance Based on VIX Levels
Assuming this recent lull is not a paradigm shift for the VIX forever, it can be useful to evaluate how markets have tended to perform when volatility slumps. There are those that point to a low VIX as a sign of calmness and opportunity for significant gains. Others point to a low VIX as a “canary in the coal mine” warning for rocky markets ahead.
Historically, the truth lies somewhere in the middle. Dating back to 1993, S&P 500 (SPY) returns when the VIX is low, tend to be quite average (chart below) over 3-, 6- and 12-month time frames, with the average forward 12-month return coming in at approximately 10%, compared to an overall 12-month average return of 9.11%. Interestingly, the lowest returns typically coincide with mid-range VIX levels (20-28), while the highest returns are observed when the VIX is extremely elevated. This pattern suggests that while low volatility periods are generally stable, the most significant opportunities for returns may arise during times of heightened market uncertainty.
Source: Yahoo Finance, calculations by KAM from Jan 29, 1993 to May 27, 2024
Conclusion
The pressing question for investors now is whether the current state of the VIX is indicative of historical periods of low volatility that tend to lead to stable, average returns, or if the rise of 0DTE options and yield-enhancing ETFs has shifted the overall landscape. This evolving environment challenges the traditional interpretation of low VIX levels. We likely won't know the full impact until it’s in the rearview mirror. Therefore, remaining nimble and tactical is critical in today's markets. Embracing a flexible approach will allow investors to navigate potential shifts and capitalize on opportunities as they arise.
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