Volatility-based Equity Allocations

The VIX is high, S&P 500 goodbye?

October 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The VIX currently trades within its top quartile since 1990
  • Using volatility to time equity allocations is a widely used strategy
  • However, it is challenging to pursue this over the long-term

INTRODUCTION

The One Ring from J.R.R. Tolkien’s Lord of the Rings saga is a plain gold ring unless it is thrown into a fire, when Elvish runes appear that roughly translate into “One Ring to rule them all, One Ring to find them, One Ring to bring them all, and in the darkness bind them”.

Investors are not searching for a ring, but they love the idea of a single all-powerful signal that can be used to time markets. Unfortunately, like the One Ring, such a signal remains a fantasy.

However, there are some systematic frameworks that have more merit than others. For example, there is plenty of academic research that shows that stock market risk tends to cluster, e.g. when volatility was high, there is a reasonable probability for it to remain high in the short term. In contrast, there is little evidence that returns cluster in the short term, although they do in the long term, which is defined as momentum.

Equity market volatility has been exceptionally low between the global financial crisis in 2009 and the COVID-19 crisis in 2020, but mostly remained above the long-term average of 19.6 since then. Some market participants are speculating that markets have changed, while others argue that the elevated volatility is a foreshadowing of a severe bear market.

In this research note, we will explore the utilization of volatility as a signal for equity allocations, which is one of the classic tactical asset allocation strategies (read Defining Tactical Asset Allocation).

VOLATILITY & STOCK MARKET RETURNS

Most investors consider the VIX index as the equivalent of the volatility or risk of the stock market. Technically, the VIX represents the implied volatility from S&P 500 options, which at times differs from realized volatility. The difference between both potentially can be harvested by investors via the variance risk premium (read