Market watchers are well aware of the stock market volatility moves in the Dow Jones Industrial Average this year. On an absolute basis, the U.S. markets endured some of the largest point drops in history. In fact, the Dow fell a record 1,600 points on February 5th. There have also been several ‘white-knuckle’ days over the stock market volatility with 1,000-point daily trading ranges. At the trough, the sell-off erased $3 trillion in market capitalization from portfolio balances.
This frantic action took many investors by surprise, especially considering the calm financial market conditions of the last two years. In looking for a ‘reason’ for the selloff, many point to increase in ‘volatility’ as measured by the VIX.
What is the VIX?
The Volatility Index, or ‘VIX’, was created by the Chicago Board Options Exchange in 1993 to quantify investor sentiment. In simple terms, it measures the prices of S&P 500 Index options. When the market is falling and there is panic amongst investors, many are willing to pay higher prices for the ‘insurance’ that options can provide. As such, the VIX moves higher. When there’s panic, the cost of owning these options can double in a short period of time. This is why the VIX is known as the “fear gauge” by the media.
It wasn’t until the Financial Crisis of 2008 that the media really began covering the VIX routinely. Today, the index is rather well-known and a number of alternative investments have been created around it.
Volatility may be the new normal so market professionals, especially newer entrants who have only worked in a low-volatility environment, need to be aware of how it can affect financial markets. We highlight three areas where heightened volatility may increase demand for financial professionals.
If the latest market swoon taught us anything, it’s that the threat from fintech challengers including robo-advisors may be somewhat overblown. Robo-advisors are companies that manage client money completely through the use of computer algorithms- no human intervention. When things are quiet, this seems like a fine idea. But unfortunately, many investors were unable to log into their accounts at Wealthfront and Betterment during the market slide.1 They had no stockbroker to call for a trade.
This revealed the value of the human component in money management and is one reason we believe financial advisors aren’t going anywhere. If anything, their merit was strengthened since the sell-off.
Another reason we see increased demand for financial planners is that volatility brings a need for active management strategies. As we’ve reported, passive strategies that replicate indices have become en vogue given the relentless climb by equity markets. But in times of volatility or a bear market, active management products should protect portfolio values as they can implement defensive and contrarian strategies to take advantage of the downside movement in markets. True active management cannot be executed through an ETF or robo-advisor.
One strategy active managers have been implementing is hedging market risk by selling credit. Advisors can reduce their client’s market risk by liquidating credit-sensitive debt instruments such as corporate bonds. Since these bonds have a positive correlation with equities, reducing their allocation could help mitigate losses in a downturn and allow for continued gains on the upside by keeping the equity allocation intact.
We envisioned a better trading atmosphere for 2018 with our year-end predictions. And we certainly have gotten it with increased volatility. Traders revel in volatility since sharp market moves allow nimble traders the ability to catch outsized moves insecurities.
One group of traders has really seen an uptick in profitability during the correction- market makers. These traders stand ready to maintain an orderly market- that means to be willing to buy (bid) or sell (offer) a security at a price. These traders make markets in everything from stocks and bonds to options and even bitcoin futures.
When volatility spikes, they can widen their bid-ask spreads to ensure they can still provide liquidity without losing their shirts. This increases their profitability immensely, especially with market orders during a frantic market action. In fact, one theory in how the VIX spiked was from the widening of S&P option spreads by market makers, but that has not been proven to be the case.
Further, many are betting the Trump administration will continue to relax Dodd-Frank regulation on proprietary trading, imposed in the wake of the financial crisis. This means more risk-taking and profits for major banks like JP Morgan and Wells Fargo.
Financial Risk Managers
Someone must manage the unintended consequences that extreme volatility brings to financial operations. Enter the risk manager. Proper enterprise risk management encompasses various types of risks including operational, regulatory, credit, systemic and reputational (given the recent spate of sexual harassment reports). Volatility risk is no different and severe dislocations can occur if not monitored properly.
A few weeks ago, we witnessed the implosion of an inverse ETN when S&P options prices went through the roof, sending the VIX skyrocketing. The result was a one-day drop of 90% for this particular product which was betting against volatility to increase yield. It has since closed.
Few investors viewed that outcome as even a remote possibility just weeks ago. As a result, risk managers are busy reassessing their firm’s exposure to such tail risk events. There are a number of popular alternative investments that now require a closer look.
Risk parity funds are also coming under the microscope. Created as a risk management product, these funds maintain full equity exposure while concurrently hedging with a leveraged bond portfolio.2 Some people credit this strategy to hedge fund legend, Ray Dalio.
But the strategy has now been copied so many times, the trade appears quite crowded. You can be sure that risk managers at large institutions such as pension funds and endowments are grilling the investment consultants who have been recommending these products over the last couple of years to see if they still make sense for portfolios.
Finally, if you work in the insurance space, you need to especially be aware of these risks since volatility can wreak havoc among derivatives, heavily utilized by insurance companies. According to Strategic Insights, variable annuity funds alone comprised 72% of all managed volatility assets.3
Because their work is so valuable to an organization, financial risk managers are well-compensated, reporting an average base pay of $98,757 on employment site Glassdoor.4 And at management consulting giant EY (formerly Ernst & Young), financial risk managers enjoy total compensation of up to $129,000.5 This is one reason Ernst careers are especially competitive. Many begin as risk analysts before working their way up to risk manager.
Risk managers hold a disproportionate number of advanced degrees. Financial recruiter Execu-Search is currently screening candidates for a financial risk manager position in New York City. As a requirement, they list a bachelor’s and/or Masters in Finance, MBA, or Masters in Accountancy (MAcc degree).6 For enterprise risk management positions, an online Masters of Financial Crime and Compliance Management is another interesting option can set a candidate apart.
So the next time volatility rears its ugly head in the markets, view it as an opportunity, not an impediment.