Displaying items by tag: volatility hedge

Recent fluctuations in the market have fueled investors' desire for strategies that mitigate risk. Defined-outcome exchange-traded funds, also known as "buffer ETFs," have emerged as a solution, aiming to protect investors from losses on a designated index. 

The proliferation of these funds has been remarkable, with assets ballooning to over $22 billion from under $200 million in 2018, with 169 offerings available presently. These ETFs typically offer index returns while mitigating downside risk, achieved by sacrificing a portion of potential upside gains. 

By employing various options structures, such as funds with upside caps or partial upside exposure, investors can tailor their risk-reward profiles according to their preferences. Despite operational nuances and fees, most of these ETFs have demonstrated their ability to shield investors from market downturns while offering competitive returns.

Finsum: These last five years have been critical examples of why many investors need buffer ETFs to both capture gains and hedge losses. 

In an article for MarketWatch, William Watts covers comments from Fundstrat’s Thomas Lee where he discusses why falling volatility is one of the major factors behind the stock market rally in 2023. YTD, the S&P 500 is up 16%, and the index is more than 25% higher from its lows last October. 

Equally impressive is that the stock market has recovered more than half of its losses. At its nadir, the market was down by 25% from its all-time high set in January 2022. Currently, it sits just 9% off these levels.

According to Lee, the volatility index is the biggest influence on S&P 500 performance, eclipsing other variables like the US dollar, earnings, rates, monetary, or fiscal policy. However, Lee’s view is not the consensus as many continue to see the market as being in a bear market rally rather than a new bull market.

These skeptics point to historically high valuations for the stock market in addition to analysts’ expectations of a modest decline in earnings per share over the next few quarters. Another headwind is that inflation continues to be stickier than expected resulting in the Fed continuing to hike further. 

Finsum: Fundstrat’s Thomas Lee was one of the few to be bullish on stocks entering 2023. He remains bullish and believes the plunging volatility index is a major factor driving returns.

In an article for MarketWatch, Mark Hulbert discusses the collapse of the volatility index (VIX) over the last couple of months, and why it could be a harbinger of a sustained stock market rally according to historical data. 

According to Hulbert when the VIX reaches a fresh, 3-year low, it’s likely to remain low for a couple more months which implies further gains for equities. However, this view is contrary to the consensus expectations on Wall Street which see further erosion in the economic outlook, causing the economy to stumble into a recession. This perspective sees the low Vix as a sign of complacency rather than a ‘continuation’ signal.

Hulbert points to history. Since 1990, the best performing months from a risk and return perspective, have come with low VIX readings. Based on this data, investors should increase equity allocations as the volatility index declines and reduce it as it rises.

Another benefit of this strategy is that it dampens the impact of volatility on the portfolio which increases the odds that investors will stick to their investment plan and not let the market’s twists and turns shake them out of their holdings. 

Finsum: Many on Wall Street see the plunge in the volatility index as a contrarian signal, implying complacency. Mark Hulbert disagrees and sees it as the start of a sustained rally.

In an article for Bloomberg, Larry Berman discussed recent improvements in stock market breadth, and what it could mean for volatility. One defining feature of the stock market rally has been the limited participation as the bulk of gains have been driven by the tech sector and a handful of mega cap stocks. 

But, this is now changing as economic data continues to come in better than expected, and more parts of the market are joining the rally. According to Berman, this is an indication that the market rally could be in its early innings which means that recent weakness in volatility is likely to linger. 

Berman labels this as a ‘bullish divergence’. However, he notes that future contracts of volatility are not yet depressed as the front-month contract. This is an indication that the market does expect volatility to pick back up in the second-half of the year which is also consistent with many analysts who see the economy falling into a recession by then. 

He believes that some sort of catalyst is necessary for the bearish scenario to develop which isn’t evident at the moment. This is especially the case as many of the ‘risks’ faced by the market at the start of the year haven’t materialized. 

Finsum: There’s an interesting divergence in the market with front-month volatility depressed, while future contracts remain elevated. However, improving market breadth may signal that future month contracts may also move lower in the coming weeks. 

One of the surprising developmentds of 2023 has been the strength in equity markets and subsequent decline in volatility. Currently, the VIX is trading at its lowest levels in the last couple of years despite many headwinds such as a slowing economy and a hawkish Fed.

In Barron’s, Nicholas Jasinski discusses whether the decline in volatility is temporary or will it be sustained for the rest of the year. He notes that many of the market’s worries have eased such as Republicans and Democrats coming together to raise the debt ceiling, the regional banking crisis has seemingly passed, and economic data continues to come in better than expected.

On top of this, investors have been on the sidelines with most inflows into fixed income or defensive strategies, while short interest also remaisn elevated. The net result is that the S&P 500 is up more than 20% from its October lows, and many believe a new bull market has started. 

Whether these gains will sustain and volatility will continue trend lower will depend on factors like inflation, the Fed’s rate path, and credit conditions. However, it’s clear that the market has climbed the bulk of its ‘wall of worry’.

Finsum: Volatility is at its lowest levels since before the bear market began. How it will fare in the coming months will depend on inflation, the Fed, and whether credit conditions continue to tighten.