What is the VIX index and how can SMSFs use it?
The VIX index has become a buzzword in financial markets. But its usefulness is often misunderstood by investors and taken as a general proxy for risk, which is a mistake. Nader Naeimi, Head of Dynamic Markets, explains the VIX index and how you can use it to assess investments.
The VIX index has become a buzzword in financial markets. But its usefulness is often misunderstood by investors and taken as a general proxy for risk, which is a mistake. In fact, it’s a very specific measure.
VIX is the ticker for the Chicago Board Options Exchange (CBOE) Volatility Index, and indicates the market's expectation of 30-day volatility.
Everyone’s talking about it but self-managed super fund investors should bear in mind all it measures is the implied volatility on S&P 500 options. People assume when the VIX is low, volatility is too low and when it rises, people think volatility will worsen.
But that’s not the case all the time, so the starting point is an understanding of what the VIX measures and how to use it in combination with other indicators.
It’s a short-term indicator, and because it measures implied volatility in options, it doesn't always equate to realised volatility. Sometimes realised volatility for the S&P 500 is lower than the VIX.
The VIX has to be understood in context. We look at implied volatility but we combine it with other measures. So we look at implied volatility across other indices, not just the VIX, which only refers to the S&P 500.
It’s also important to look at the volatility curve, for instance how the VIX, or near-term volatility, is trading relative to longer-term volatility.
Short-term volatility may be low, but if you look at the curve out to six months, it might be a lot higher.
In this situation, if there is a larger amount of protection, that is if people are buying more puts than calls, it reflects healthy scepticism. I usually say the time to worry about risk is when no one else is – risks are usually high when there is a perception there are no risks.
Indeed, while volatility and risk are important, it’s also critical to look at demand for protection, which is the relative demand for puts versus calls, known as the put/call ratio.
Puts and calls are derivative instruments known as options. A call gives the investor the right but not the obligation to buy the underlying security at the exercise price and a put gives the investor the right but not the obligation to sell the underlying security at the exercise price. You buy a call if you think the market will rise and sell if you think the market will fall, the reversed being true of a put.
When people drop their guard and buy more calls and not enough puts, that's when there are complications in the market. People have forgotten about risks and that's usually when you worry about a correction.
Additionally, when the VIX is very low, it doesn't mean that an equity bull market is on its last leg and there's a risk of a bear market, all it does is suggest that there’s a risk of correction.
The VIX is one measure that indicates the possibility of a correction. But it’s also important to consider other, fundamental measures of value.
It’s important to look at the VIX in the context of market valuations. When markets are extremely expensive and VIX is very low, that's a risk.
But we also need to consider the earnings and economics cycle. If the economic cycle is improving, earnings are recovering and the VIX is low, there may be the possibility of a correction, but the likelihood of a bear market is low.
Central bank policy and interest rates also play a part. Let’s say central banks are raising rates and inflation is very high and the VIX is low. That's a bigger risk than when the VIX is low, valuations are comfortable, the economics cycle is positive and monetary policy is not too restrictive.
For AMP Capital, the VIX is just one indicator within one driver used to valuate markets.
We have five drivers, including valuations, economic cycle, monetary policy, market sentiment and technical drivers. VIX is one indicator within our sentiment driver. It’s essential to look at all five drivers and figure out if they confirm each other.
Above all, it’s important for SMSF trustees to understand risk is two-dimensional.
You can't just worry about downside risk and forget upside risk; risk is symmetrical. People spend too much time worrying about downside risk and forget about upside risk.
Downside risk is the potential for losses, whereas upside risk is the potential for falling short of investment objectives. Risk and return are two sides of the same coin.
Always look at risk and return together and use the right indicators. This allows you to switch off your emotions, which is important in being disciplined and enhancing investor returns.