Must-know: The last cheap asset class

Market Realist

Overview: The last cheap asset class (Part 1 of 2)

With cash paying nothing and long-dated bonds barely keeping up with inflation, investors have bid up most asset classes in search of a decent return. However, according to Russ, there is one asset class that still looks cheap: volatility.

Nearly six years into the Federal Reserve’s  unprecedented experiment in unconventional monetary policy , nearly every asset class is starting to look pricey.

With cash paying nothing and long-dated bonds (TLT) barely keeping up with inflation, investors have bid up most asset classes in search of a decent return. However, according to Russ Koesterich, there is one asset class that still looks cheap: volatility (VXX). BlackRock and other market watchers have increasingly taken the view in recent years that volatility is an asset class, accessible through funds that track volatility indices and other strategies, that can potentially help reduce portfolio risk and increase returns.

Market Realist – Volatility (VXX) has been the most critical component of options-pricing models. However, it has rarely been a significant portfolio concern for pension and mutual-fund managers and other institutional investors. As a result of the financial crisis, many have been forced to consider augmenting the Modern Portfolio Theory—a guiding principle in many investment portfolios that advocates diversification as a means of limiting risk. Thomas McFarren, part of BlackRock’s Global Market Strategies Group, advised in an Investment Insights essay that selling volatility as an equity substitute would have improved portfolio performance, even during the financial crisis. In other words, it can be used as an additional asset class to diversify the portfolio and reduce risk.

Last week, U.S. equity market volatility, as measured by the VIX Index, hit 10.34, the lowest level since early 2007 and roughly half the long-term average. A similar pattern of low volatility is visible across asset classes and geographies.

Market Realist –  The VIX Index tracks the implied volatility  of  S&P 500  (SPY)  options. The VIX has hit the lowest levels since 2007 and the highest since 2012. Relative to historical values, it’s currently low, but has been lower—for example,  2005–2006). In 2007, the low for the VIX was 9.89, although the high was a steep 31.09. In other words, the VIX was low in 2007 and is low now as well. Volatility tends to revert to a mean over time and that mean is higher than where we are right now. The key question is when will it snap back up.

Retail investors can invest in volatility very easily. There are several exchange-traded funds (or ETFs) that track the VIX Index short term futures. The most well known is the  iPath S&P500 VIX Short Term Futures ETN (VXX). The  ProShares Ultra VIX Short Term Futures ETF (UVXY) is a far second in terms of assets and daily volume. There are also inverse ETFs that track the inverse return of the index, which make it easier to short volatility. The main one is the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), followed by the ProShares Short VIX Short-Term Futures ETF (or SVXY).

Read on to understand why volatility is currently so low.

Continue to Part 2

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