BT: With stocks, volatility is your friend (14 Feb 2007)

With stocks, volatility is your friend

With volatility comes the prospect of what investors want: excess returns

(LONDON) Investors worry that an end to super-low market volatility could spell the death of the bull run in stocks, but a Barclays Capital study argues that greater volatility is necessary for prolonged equity out-performance.

The past four years have proved a boon for stock markets across the globe, buoyed by a glut of liquidity generated by inexpensive borrowing costs, the strongest run for corporate profits in 30 years and the absence of volatility.

Volatility, measured by the Chicago Board Options Exchange Volatility Index or VIX, has been trending lower since 2003. Known as Wall Street's fear gauge, the VIX hit a 13-year low of 9.39 per cent in December and remains stubbornly close to 10 per cent. A widely held view is that such low volatility is a key component of the sustainability of the current rally, marking it out as a different kind of beast from the technology-led surge of the late 1990s which imploded in the early part of this decade as volatility spiked to almost five times current levels.

But the Barclays Capital study suggests long-term equity investors should take a more sanguine view on volatility. 'The volatility of asset returns is actually the investor's friend, not their bane. For without volatility, there can be no excess return,' Tim Bond, head of asset allocation at Barclays Capital said in the firm's Equity Gilt strategy paper released last week.

Excess returns have certainly been a feature of recent years. MSCI's world index has more than doubled since March 2003 while its emerging markets counterpart has more than tripled over the same period. Major indexes in the United States and in Asia excluding Japan are at record peaks, and European shares are at levels not seen for more than six years.

But despite the blockbuster run, stocks have struggled to attract broad-based buying.

Small-scale individual investors were left licking wounds from the bursting of the tech bubble, while pension funds have been regulated to match their long-term liabilities with secure, long-term fixed income assets - assets also favoured by increasingly wealthy Asian nations and oil-rich economies.

Compared with low risk government bonds, equity risk premiums - the additional returns received for holding more volatile stocks - have risen to elevated levels, while price to earnings valuations compare favourably to long-run averages.

Trade off

BarCap's equity risk premium research suggests returns from stocks are likely to outperform bonds over the next five to fifteen years, with excess returns from cheap European stocks seen at a higher-than-average 7-8 per cent over the next decade. And even the excess volatility and risk of loss from holding shares diminishes over time, especially when inflation is high, BarCap said.

Mr Bond reckons the reluctance of investors to get back into 'riskier' stocks is instinctive, since sensitivity to downside volatility - such as losing half your retirement savings - is much more acute than to upside volatility.

In financial markets, that means costs to hedge against sharp falls are high and can quickly eat into profits, undermining the very rationale for owning stocks at all.

But Mr Bond is realistic about the likelihood of investors and their accountants and regulators embracing volatility. Some higher level of volatility is simply a necessary evil if the longer-term out-performance of equities as an asset class is to be sustained, he reckons.

'The holy grail of investment is always going to be the best risk/return trade-off and equity volatility is likely to remain an undesirable property for most investors,' he said. - Reuters

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