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After an extended period of calm and buoyant markets, February was a bit of a wake up call to investors as markets sold off and volatility surged to levels not seen since crisis times, comments Prasaanna Jeyanandhan Analyst for SYZ.
This spike in volatility, coming during a so-called "Goldilocks" period of strong growth and modest inflation, caught many investors off-guard as equity markets lurched downward on the back of fracturing short volatility investments. The sudden return of volatility has sparked a debate as to what it means for markets going forward. Volatility, often viewed as a gauge of investor fear, is seen by many as a headwind for markets. As contrarian investor, Prasaanna Jeyanandhan, Analyst for SYZ, disagrees. Volatility provides investment opportunities as periods of panic often trigger irrational sell-offs opening up pockets of value to be exploited by long term investors.
Over the course of 2017, this was one of Jeyanandhan's key contrarian themes as he built up positions in stocks geared into a normalisation of volatility from all time lows. While he was convinced that it would normalise, the difficulty was predicting when it would occur and what would trigger it. For him, perhaps unlike many others, February was an encouraging month; not just in terms of relative outperformance as some of our volatility plays began to work, but mainly in validating Jeyanandhan's longer term view that volatility is normalising and that this should benefit the funds as a result.
Betting against the short volatility trade
2017 was a difficult year for finding contrarian investment themes. Synchronised global growth, strong corporate earnings and loose monetary policy combined in support of broad market strength. However, the remarkably sanguine behaviour of equity markets to bouts of uncertainty, whether geopolitical or other, led Jeyanandhan to believe that volatility could be an interesting contrarian idea. SYZ's analysis suggested that the short volatility trade was more widespread than thought as systematic strategies such as short vol ETFs, risk parity, vol targeting and CTAs crowded in.
This suppression of volatility fed back into risk models supporting increased leverage and further market appreciation. "Volatility was dead" concluded some investors and market commentators. The SYZ analysts had heard this before when investing in emerging market exposed stocks, luxury goods and many other contrarian themes, and it rarely proved to be the case. Jeyanandhan saw this as an opportunity and began building positions in market infrastructure stocks that would benefit from increased trading activity if and when volatility began to pick up. On the other side, he reduced his positions in asset management companies in the belief that these would struggle in more choppy markets. The analyst complemented his existing positions in the stock exchanges by adding other market infrastructure companies like Flow Traders (a leading ETF market maker) as well as the inter-dealer brokers TP ICAP and NEX Group. This gives him exposure to volatility across equity, fixed income and FX markets.
One months vol spike does not necessarily mean a structural normalisation, although Jeyanandhan is encouraged by the developments in February. The path of monetary tightening and gradual withdrawal of central bank liquidity will, he thinks, lead to a pick up in volatility over the longer term which should benefit the positions he has added. Jeyanandhan remains optimistic that this contrarian theme will play out in the coming years.