Low Volatility Won't Last Forever |

Low Volatility Won’t Last Forever

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From WisdomTree: One of the signatures of the bull market in U.S. stocks over the past five years has been its incredible complacency.

One way to visualize the lack of fear in equity markets is to examine the CBOE Volatility Index (the VIX). The VIX, currently trading around 10, scraped a 20-year low of 9.36 on July 21. This is well below its average of the last 20 years, which is about 20.

Figure 1: CBOE Volatility Index, 7/29/12 -7/29/17

CBOE Volatility Index Performance

The VIX is important because it governs the pricing of options and the premiums investors can collect when writing them on the S&P 500 Index. For most of the last five years, the VIX has averaged about 15, a 25% discount to its historical average. But in recent weeks it has traded between 9 and 11. During periods of unusually low fear in the market, it is not unusual to see investors bidding up stocks to new highs. The current low-volatility environment reminds me a little of the period between late 2004 and May 2006, when the world was also awash in liquidity. Over that period, with volatility grinding ever lower, U.S. equity markets climbed 20% over 20 months, unaware that a historic financial crisis was waiting just around the corner.

These periods of unusually low volatility can continue for months or years, but typically they end with an unforeseen shock to markets that makes such complacency seem surreal in retrospect. For contrarian investors who view today’s complacency as a prelude to an eventual (and highly volatile) reversion to the mean, WisdomTree has a few tools in its tool kit designed to help investors reduce volatility in their portfolios.

Reducing Volatility While Collecting Premiums on the Market 

One way to potentially collect option premiums on the S&P 500 Index is by investing in the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW), which seeks investment results that, before fees and expenses, generally correspond to the performance of the CBOE S&P 500 PutWrite Index (PUT). PUTW invests in one- and three-month Treasury Bills and sells or “writes” S&P 500 Index put options. The Fund writes monthly “at the money” European-style options, and the number of put options sold is chosen to ensure full collateralization. The option premiums the Fund receives from selling puts can help mitigate the negative effects of investing only in investment vehicles that track the S&P 500 Index.

Now that PUTW has nearly a year and a half of real-time history, we can measure how it has performed during a period of historically low volatility in the market. As we can see in figure 2, during this period, when the S&P 500 Index advanced 21% on an annualized basis, PUTW was still able to generate 13% annualized returns–even though it did not own stocks during this period. Notably, over the last year, the combination of owning Treasury Bills and collecting option premiums on the S&P 500 generated returns that exceeded those posted by the MSCI USA Minimum Volatility Index, an equity index, which advanced 8.30% over the same period.

Figure 2: Risk and Return Data for PUTW, 2/24/16-6/30/17

Cumulative Returns of PUTW

PUTW Risk Since Inception

When we drill down to review the standard deviation and beta of the fund based on daily price data over the period, we also noticed that PUTW exhibited much lower volatility than either of the equity indexes, with a beta that was less than half of the S&P 500. This resulted in a Sharpe ratio, a measure of risk-adjusted return, that was higher than the S&P 500 or the MSCI USA Minimum Volatility Index. While these risk-return numbers reflect this particular time period and may not be representative of what investors may experience in a downward trending equity market, it is worth noting PUTW’s potential to generate attractive returns per year, with low volatility, in a period where overall VIX levels were subdued.

Conclusion

Equity investors have enjoyed a period of unusually low volatility in U.S. equity markets. This period of prolonged calm in the market has coincided with an extended upward climb in U.S. stock prices. While these periods of relative complacency can continue for months or years, they can also turn suddenly, because of unforeseen market shocks. PUTW, which has performed well in a period of relative calm in equity markets, has also historically provided a way for investors to lower the overall volatility compared to traditional equity exposures.

Important Risks Related to this Article

Double-digit returns were achieved primarily during favorable market conditions. Investors should not expect that such favorable returns can be consistently achieved. A fund’s performance, especially for very short time periods, should not be the sole factor in making your investment decision. There are risks associated with investing, including possible loss of principal. The Fund will invest in derivatives, including S&P 500 Index put options (“SPX Puts”). Derivative investments can be volatile, and these investments may be less liquid than securities, and more sensitive to the effects of varied economic conditions. The value of the SPX Puts in which the Fund invests is partly based on the volatility used by market participants to price such options (i.e., implied volatility). The options values are partly based on the volatility used by dealers to price such options, so increases in the implied volatility of such options will cause the value of such options to increase, which will result in a corresponding increase in the liabilities of the Fund and a decrease in the Fund’s NAV. Options may be subject to volatile swings in price influenced by changes in the value of the underlying instrument. The potential return to the Fund is limited to the amount of option premiums it receives; however, the Fund can potentially lose up to the entire strike price of each option it sells. Due to the investment strategy of the Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.


The WisdomTree CBOE S&P 500 PutWrite Strategy Fund (NYSE:PUTW) was unchanged in premarket trading Thursday. Year-to-date, PUTW has gained 7.35%, versus a 11.63% rise in the benchmark S&P 500 index during the same period.

PUTW currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #3 of 21 ETFs in the Alternative ETFs category.

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