Chad Padowitz

As US market volatility, as measured by the VIX index*, touches lows not seen since early 2007, an extraordinary calm has fallen over US markets, says Chad Padowitz, Chief Investment Officer at global equities manager Wingate Asset Management.

“The big unsettling dynamic in US markets is volatility. Since late 2011, as markets moved higher, volatility has trended lower.

“The market’s extraordinary calm is illustrated by the S&P 500’s daily return, which has not exceeded +/- 1% for 51 consecutive trading days up to 30 June 2014, a period of some two and a half months.

“This is the longest period of calm since 1995. Though low volatility is not by itself a requirement for future market weakness, we believe it is a good barometer of elevated market risk.

“Only time will tell when world markets will see an upswing in volatility, but there is plenty in the mix to suggest its near-term possibility.

“One source may be disappointing US corporate earnings later this year. Consensus expectations anticipate earnings per share to increase approximately 14% for both 2014 and 2015. Given the long-term trend is around 6%, we see this as an unlikely outcome, especially with the backdrop of a rising rates environment,” Mr Padowitz says.

Whether they are assessing market volatility, or assessing regions and sectors, it is important for investors to think differently and look through the immediate data, and take a smoother, less risky approach to international investing, Mr Padowitz says

By way of example, he cites the recent renaissance in the US energy industry, which has been driven by growth in shale oil and other unconventional sources, as an area where many investors are not undertaking a critical “look through” of the available data.

The dramatic upswing in US shale oil production is having a significant impact on the global energy market, he says.

“As well as the related domestic economic benefits, advantages include geographic wealth diversity, reduced foreign policy risk and increased local manufacturing competitiveness. If not for this supply change, our view is that oil prices would have risen significantly, as conventional production has declined over this period.

“Despite the good news on production growth, we believe the immediate investment opportunity is less compelling.

“In this instance, it is critical to understand that the characteristics of the shale oil wells used in production mean capital requirements to achieve growth are significantly higher than for conventional production”.

Mr Padowitz explains that the average decline rate of a US shale well ranges between 35 to 60 percent a year, therefore, within four to five years, most wells become almost obsolete.

“Faced with such high decline rates, it’s a challenge to continue increasing production and producers are consistently drilling more and more wells to maintain and grow supply.

“A secondary feature, and a compounding one from an investment perspective, is that the bulk of new shale oil growth is coming from smaller companies. By their nature, these have less diversified sources of cash flow and inferior access to capital. So it’s no surprise that debt levels are more elevated in this industry.”

He says this creates an unsettling investment dynamic.

“Because every spare dollar of cash flow has been thrown at capex, overall production has rapidly grown. But the industry, we believe, will ultimately approach a tipping point, where production growth must slow as the declining existing inventory starts to exceed the growth rate of new wells.

“Call it an ‘emperor has no clothes’ moment, but it’s difficult to see earnings doing anything but declining, particularly with relatively leveraged balance sheets.”

Despite this, analyst ratings do not on the whole reflect this inevitable long term decline, he says.

“The take out for investors is this: be it prolonged levels of low market volatility or increasing capital intensity in the US shale oil industry, risk never takes a permanent holiday. This is why investors need to take a smoother, value-orientated approach to their international investment portfolios,” Mr Padowitz concludes.

*The VIX index is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.

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Simon Ho

Grant Samuel Funds Management and Triple3 Partners have warned investors not to take market returns for granted, as the CBOE volatility index – the VIX – hits near record lows.

The VIX index, often referred to as the Fear Index, is a measure of expected volatility on the S&P500 Index over the next 30 days. High VIX readings mean investors see significant risk that the market will move sharply, either up or down.

The VIX hit a low of 11.32 in May, and in the past a low VIX has frequently been a harbinger of significant market falls, says Mr Simon Ho, founder and chief investment officer of Triple3 Partners.

“This period could be the calm before the share market storm,” he says.

“The last time the VIX was at these low levels was at the start of 2007, the period immediately before the onset of the GFC.

“I expect that volatility levels will start to climb higher by the end of 2014, with a lot of uncertainties ahead for world economies.

“There is the housing bubble in China which will start to deflate at some point, the experimental quantitative easing taking place in Japan which will have unknown consequences, and the US’ decision to unwind its quantitative easing program which should see asset prices and risk premiums in that country return to more normal levels.

“Throw into the mix the conflagration in Eastern Europe, and the Euro-zone being on the verge of deflation, and you have a number of banana skins on the road ahead, waiting to trip-up the unwary.

“The backdrop against this is that equities are very fully priced. We have seen five years of a bull market where the S&P has gone from a low of 666 to sit at its current levels above 1900.

“Investors can’t afford to be complacent about their portfolio diversification,” Mr Ho says.

Along with a mix of equities, bonds, cash, alternatives and property, investors can also diversify by investing in volatility itself.

“Most investors see volatility as risk, but it is increasingly being recognised as a distinct asset class, and one which offers a largely untapped source of portfolio returns that are largely uncorrelated to equities.

An investment in volatility can be accessed through the VIX with the use of options and volatility derivatives. Mr Ho says it is a good natural diversifier.

VIX options have been one of the fastest growing option markets in recent years and now rank as one of the world’s most liquid – regularly trading over 1 million options contracts per day.

The Triple3 Volatility Advantage Fund, which is distributed in the Australian market by Grant Samuel Funds Management, aims to generate long-term absolute returns with its volatility-focused strategy to capture alpha from highly liquid exchange-traded VIX options, which are negatively correlated to equities.

Mr Damien McIntyre, director and head of distribution with Grant Samuel Funds Management, says: “The investment strategy is expected to perform best in periods where the S&P is falling. In periods where the S&P is choppy, the investment strategy is expected to generate positive returns, and where the S&P remains stable or increases only steadily, the investment strategy is expected to generate cash-like returns.”

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