Drivers behind the rise in market vulnerability

It is widely believed that recent years have suffered historically high volatility in stock market returns. Rodney Sullivan of CFA Institute puts today’s market volatility into historical context, and discusses the various sources underpinning market riskiness.

How does recent market volatility compare historically?

The most recent few years have certainly seen relatively high market volatility. But since 2000, a period widely viewed as encompassing high uncertainty,market volatility is in line with long-term historical averages.

For example, from 2000 to 2011, the annualised market volatility for MSCI EAFE was 19 per cent as measured by standard deviation of returns, which is consistent with that observed during the past 40 years (1971-2011).

Interestingly, looking further back in time, even most recent market volatility is not a jaw dropper. For the 40-year period 1926-1971, large-cap US stocks demonstrated a 25 per cent annualised volatility as compared to around 22 per cent during the most recent three years

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

Looking back, market volatility, while certainly the highest most of us can recall, is 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 autumn 2008 and the so-called “flash crash” in May 2010.

Are markets now more susceptible to these sudden disruptions?

Yes, markets increasingly appear hypersensitive to unexpected news or events.

Why is market vulnerability on the rise?

Studies suggest a number of possible culprits. Assets invested in passively managed equity mutual funds and exchange traded funds have grown steadily in recent years, reaching more than $1tn by the end of 2010. More important, 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 increases market correlation to unexpected news or events – undesirable for markets.

What are the other reasons behind the rise in vulnerability?

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, there is the role human behaviour plays in market activity and aberrations. As social animals, certain embedded cognitive and emotional behaviours lead us to make errors in judgment precipitating market disruptions. We are often over-confident in our ability to manage investment risk leading us to fall into the trap that the future is predictable rather than uncertain.

What does this increased vulnerability mean for investors?

Whatever the drivers behind the rise in market vulnerability in recent decades, the result is 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. 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, appears a more risky prospect for investors. Investors can improve their investment processes by incorporating the impact of increased market risk into their risk-modelling and asset allocation framework.

Rodney Sullivan is head of publications at CFA Institute