As investors grow more familiar with the exchange-traded product structure, many have started to utilize these instruments for tactical exposure and not just as buy-and-hold building blocks in their portfolios. After equity markets logged a stellar performance in 2013, volatility has rightfully been a key concern for many investors looking to navigate this year’s ups and downs on Wall Street. Andy O’Rourke, Managing Director and Chief Marketing Officer at Direxion, recently took time to discuss some of the headwinds that could plague markets in 2014, in addition to explaining the differences between two seemingly identical low-volatility strategies.
ETF Database (ETFdb): Broadly speaking, what are some high-level expectations that you have about volatility levels in 2014 compared to the environment seen last year?
Andy O’Rourke (AR): We have been in a period of historically low volatility for quite some time. Outside of a few brief spikes post-credit crisis, the VIX has been mostly below 20 for the past few years. This low-volatility environment has coincided with a strong run in equities. The bull market in equities has entered its sixth year. The S&P 500 had its largest annual jump in 16 years in 2013 and as of 4/15/2014 the cumulative return of the index is up 203% from the 3/9/2009 low [see also Low Volatility ETFdb Portfolio].
We also haven’t experienced a 10% or greater correction in quite a while. Most investors have become complacent and increasingly bullish because of this. The market historically has been very effective at correcting extremes and excesses in both directions. It does seem likely that at some point in the near future, volatility will rise and return to historically average levels. If history tells us anything, that development will likely coincide with a market correction, as market performance and the VIX are negatively correlated for the most part. The timing, duration and size of the increase in volatility are the big questions.
So far this year we have already seen volatility trend upwards and spike a bit in response to a few unexpected market-moving events, such as the turmoil in emerging markets (specifically China), geopolitical concerns (Russia/Ukraine) and hawkish commentary from the Fed indicating that interest rates could rise sooner than previously expected. The VIX ended the year slightly below 13 and quickly rose above 20 in early February before falling back a bit, but it’s still up more than 13% for 2014 so far (as of 4/15/2014).
ETFdb: In terms of headwinds, what do you think is arguably one of the more understated risks that could plague U.S. equity markets this year?
AO: There are many headwinds facing the equity markets, but in keeping with the theme here, probably the most understated risk is the looming increase in volatility. We do hear a fair amount on a day-to-day basis about the VIX and what the level of volatility is in the markets in general, but we don’t often hear too much about the impact higher volatility can have on the performance of equities over time. We find that many people are undereducated on this concept [see also Andy's Explanation of How Leveraged ETFs and Compounding Work].
There are several other headwinds that may impact the markets, including:
- Geopolitical risks, such as the situation involving Russia and the Ukraine, which could escalate.
- Interest rates rising faster and sooner than expected.
- Rising inflation.
- Unemployment not decreasing as fast as expected, or even increasing.
- Slowing economic growth (some economic readings have been below expectations).
- Slowing earnings growth (there were some high-profile misses in Q1).
- Slowing economic growth overseas (China).
- Consumer slowdown.
All of these headwinds can create a stormy market environment. As investors consider all of these factors, and the chance that many could occur simultaneously, they should be looking for some investment vehicles that provide downside market protection.
ETFdb: What advice would you give to investors who are looking to smooth out volatility in their portfolios, but are wary of giving up exposure to the strong bull market at hand?
AO: We find these days that most investors, particularly those that have already accumulated some wealth, are primarily focused on preserving their capital. In a broad sense, this translates to creating a portfolio that is very well-diversified and provides a significant amount of downside protection. Everybody loves to obtain the maximum benefit from the equity markets when they are rallying, but it is important to create a portfolio that includes exposure to various asset classes, including alternatives, which have a low correlation to traditional asset classes [see also How To Be A Better Bear: Short Selling vs. Inverse ETFs?].
Direxion has developed an ETF that offers a very interesting way to gain exposure to broad equities with a built-in methodology that provides protection against adverse, volatile markets. The Direxion S&P 500 DRRC Volatility Response Shares ETF (VSPY) is a rules-based strategy ETF that provides investors with exposure to the S&P 500, but modifies this exposure level based on how volatile the markets are at any point in time.
High volatility is often a precursor to a bear market, and can certainly deliver significant drawdowns that all investors look to avoid. VSPY is designed to self-adjust its exposure to the S&P 500 based on the amount of volatility present in the market. When volatility is low the fund will be fully invested in equities, but if volatility is higher the exposure to equities will be gradually scaled back, and the difference will be invested in T-bills.
AO: These strategies are similar in that they are both seeking a common goal of providing investors with a way to experience the return potential of equities, but at the same time, limit their exposure to severe volatility. The methods of achieving this, however, are different. Many low-volatility funds in the market are looking to identify particular stocks that are expected to offer lower volatility, as compared to the rest of the stocks in the S&P 500. However, this is done by assessing those stocks’ volatility levels over the past 12 months. While this is certainly the best information available, there is nothing that says their volatility will not pick up substantially in a very short period of time. We have seen this time and again. These types of products also tend to have a bias towards certain low-beta sectors, so diversification across various equity sectors can sometimes be impacted.
Direxion’s VSPY looks to achieve the low-volatility goal by consistently providing proportionate exposure to all stocks in the S&P 500, but adjusting exposure to the entire benchmark based on the overall volatility of the benchmark. Historically, performance has typically strengthened when volatility has been low, presenting a good opportunity to be fully invested. Conversely, during periods of high volatility, performance has weakened, indicating a good time to decrease exposure to the index and put a portion of the fund’s assets into T-bills.
What’s nice about VSPY’s methodology is that it uses a very straightforward formula to determine the desired exposure level, which makes the fund very simple to understand for investors. The overall goal is to provide returns that are comparable to that of the S&P 500, but with reduced volatility, or standard deviation. The fund has done well in this regard since it was launched in January 2012.
The Bottom Line
Investors can protect their portfolios from the adverse effects of rising volatility in a number of ways thanks to the proliferation of ETFs; whether its inverse ETFs, bonds funds, or low-volatility focused strategies, there is no shortage of instruments out there that can help smooth out a bumpy ride in the markets. Direxion’s VSPY warrants a closer look under the hood from anyone looking to achieve exposure to the ongoing bull run in equities while at the same time maintaining the ability to dynamically scale back on risk if warranted.
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Disclosure: No positions at time of writing.