Is Market Vulnerability on the rise?

This article was published in Arab Times.

It is widely believed that recent years have suffered historically high volatility in stock market returns. Following an earlier article in the Financial Times (FTfm supplement) Rodney Sullivan, Head of Publications at CFA Institute and Mandagolathur Raghu, President of CFA Kuwait both put today’s market volatility into historical context, and discuss the various sources underpinning market riskiness over time.

How does recent market volatility compare historically?

Recent years had seen relatively higher market volatility. However, many observers would be surprised to know that since 2000, a period widely viewed as encompassing high uncertainty, markets have demonstrated market volatility near long-term historical averages, overall. For example, from 2000 to 2011, the annualized market volatility for MSCI to Europe Australasia and Far East was 19 percent as measured by standard deviation of returns. However, that same level of volatility is consistent with that observed during the last 40 years (1971-2011). Interestingly, looking further back in time, even recent market volatility is not a jaw dropper. For the 40 yr period 1926-1971, data shows that volatility for large-cap U.S. stocks demonstrated a 25 percent annualized volatility as compared to around 22 percent during the most recent three years.

How do the GCC markets measure up on this?

In general GCC markets exhibit higher risk compared to emerging markets, but GCC markets lack extensive history and therefore we should be cautious before making any definitive conclusions. However, going by the standard metric for risk i.e., standard deviation, the near term risk for GCC markets is lower than long term risk in line with the trends observed above. The annualized risk for the last two years for S&P GCC index is 15% while the same for the last 5 years is nearly 25%. Even other risk measures point to the same trend. For example, the maximum drawdown (defined as peak to trough fall) during the last 2 years was 10%, while the same for the last 5 years was a staggering 62%.

Markets are therefore as risky now as in the distant past?

Looking back, market volatility, while certainly the highest most of us can recall, it’s not at all unprecedented. However, volatility is but one measure of risk. Additional consideration should be given to other measures such as available liquidity, the amount of leverage employed, and portfolio drawdown associated with market disruptions, where markets suddenly exhibit large negative returns as witnessed during the global financial crisis in fall 2008 and the so-called “flash crash” in May 2010. Are markets now more susceptible to these sudden disruptions? Even though overall standard deviation is now roughly in line with historic measures, standard deviation is but one measure of risk. Research has shown that markets are more vulnerable now to sudden reversals than formerly. So, yes, markets increasingly appear hypersensitive to unexpected news or events impacting markets adversely.

Why is market vulnerability on the rise?

Studies suggest a number of possible culprits for the rise in market vulnerability. Assets invested in passively managed equity mutual funds and exchange-traded funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion by the end of 2010. More importantly, ETF trading now accounts for roughly one-third of all trading. ETF trading is accomplished largely by basket trading or the simultaneous buying or selling of the many stocks within a given index. Consequently, stocks within that basket or index tend to move together throughout the trading day. This, in turn, increases market correlation to unexpected news or events—an undesirable effect on markets.

What are other reasons behind the rise in vulnerability?

The rise in index trading is, of course, only one possible contributor to this phenomenon. A second possible source relates to active mutual funds that are managed against an index benchmark. Research indicates that the level of closet indexing among active managers has been noticeably increasing since around 1995. Given that many active funds are managed relative to specific benchmarks, say the S&P 500 Index, their trading is likely to be concentrated in underlying constituents of the respective index benchmark. As such, these funds may also contribute to the rise in market risk through basket-type trading. Another possible source relates to the rise of various quantitative investment strategies. Overall growth in such investing may contribute to periodic disruptions as all quant managers find they are trading the same securities on the basis of similar quant-driven signals. Finally, we can also look to the role human behavior plays in market activity and aberrations. As social animals, certain embedded cognitive and emotional behaviors lead us to make errors in judgment precipitating market disruptions. Consider how we are often overconfident in our ability to manage investment risk leading us to fall into the trap that the future is predictable rather than uncertain.

Are there other reasons behind the rise in vulnerability for the GCC?

The factors which contribute to volatility in the global context (like high ETF trading or basket-type trading) may be less at play in the GCC. Index trading is still not that popular compared to active management of funds. For GCC, lack of institutional investors may be contributing to higher risk coupled with low liquidity. Domination of retail trade may also induce behavioral biases contributing to higher risk. What does this increased vulnerability mean for investors? Whatever the drivers behind the rise in market vulnerability in recent decades, the result are a meaningful decrease in the current ability of investors to diversify risk. This is particularly important for portfolio management because diversification is less effective where there is both increased market volatility, and company-specific volatility. These changes have introduced additional challenges for risk management in equity portfolio construction. Furthermore, the diversification benefits of equity investing have decreased for all styles of stock portfolios (small-cap, large-cap, growth, and value). Specifically, an investor looking to maintain the same level of risk relative to the market now needs to meaningfully increase the number of stocks held. So the ability of investors to diversify risk by holding an otherwise well-diversified portfolio has markedly decreased in recent decades. All investing, indexed or otherwise, currently appears a more risky prospect for investors. Investors can improve their investment processes by incorporating the impact of increased market risk into their risk-modeling and asset allocation framework.

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