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Volatility and the Illusion of Diversification
As we observe recent market events, what is extraordinary to us is not the sharp rise in volatility over the past couple weeks, but rather the extended periods of subdued volatility over the previous eight years. We don’t know if this marks the beginning of a “new normal.” We don’t pretend to know the future direction of the equity markets, or whether bond yields have begun an inexorable path upwards, or even whether volatility will remain at elevated levels. However, what the past fortnight has reminded us of is that volatility is a mean reverting asset, and reversion to the mean can have unexpected consequences.
It is not just investors who shorted the fear gauge through inverse VIX exchange traded funds or through option volatility mutual funds who had a brutal awakening. Many investors were likely surprised (and disappointed) to observe correlations converge across the breadth of their investments. This phenomenon where different asset classes – stocks, bonds, real estate and alternative investments – all lose value to some degree at the same time is commonly referred to as “short volatility.” In fact, our research indicates the majority of asset classes lose value when volatility rises. This raises the inevitable question: what type of portfolio will be able to withstand the impact of spikes in volatility and preserve capital?
At Water Island Capital, we have analyzed the historical data across various investment strategies with the goal of identifying those asset classes that have demonstrated resilience in withstanding large drawdowns from the re-pricing of risk. Our work indicates that while many alternative investments will likely fail to protect when markets become more volatile, there is a subset of strategies, including Merger Arbitrage, Market Neutral and Managed Futures, that can potentially protect against capital loss and deliver sustainable diversification benefits, regardless of the volatility environment.
In today’s environment, we believe our research paper on this phenomenon (“Short Volatility and the Illusion of Diversification”) is particularly relevant. If you would like to learn more, please click here to access the paper.
The "VIX," also known as the CBOE Market Volatility Index, is an index that is commonly used as a measure of domestic equity market volatility.
Past performance is not indicative of future results.