There’s a line of cinematic dialogue that has become so commonly used it is now impossible to nail down to any single film.
Most often it is said by the hero of the piece, holed up in an abandoned building or creeping through a menacing jungle, surrounded on all sides by an unseen enemy. The hero and his men ready themselves for an attack that could come at any moment. After all, there MUST be danger nearby.
Someone has to break the silence, and only one line will do: “It’s quiet…too quiet.”
It’s a sentiment I’ve heard numerous times over the last few weeks when talking to fund managers about the low levels of volatility we’re currently ‘enjoying’. I use that word hesitantly, as no one I’ve spoken to seems to be enjoying it very much at all.
“I’m lying in bed at night thinking about this,” one multi-asset fund manager told me this week. “One of the biggest risks in the market now is the fact we don’t know what the risks are, but there will be a correction at some point.”
This general distrust appears to echo the growing wariness and weariness in which asset owners regard volatility as a useful measure of risk for long term investors.
In a paper published by the 300 Club, Coal Pension Trustees Investment CIO Stefan Dunatov argued that, like the assumption that markets are efficient, the assumption that volatility is a good measure of risk is “clearly wrong”.
“Volatility measures typically inform us about the state of the world at the current time and models that forecast volatility tend to only be able to do so with any degree of accuracy over a very short time frame,” Dunatov claims.
“The most confident analysts believe six months is a long time horizon for forecasting volatility, which is of limited use to a professional investor with a medium to long-term investment horizon.”
The real problem long-term investors face, he believes, is how to deal with the uncertainty surrounding the likely paths asset prices might take over their investment time horizon.
But isn’t this simply another way of defining volatility? Not so, says Dunatov. “Instead, this is about understanding the range of possible macroeconomic outcomes, judging the likelihood of those outcomes occurring and choosing an asset allocation that best fulfils the investment objective within that context.”
It is encouraging to see both asset owners and fund managers being equally sceptical regarding the true meaning of what volatility indexes tell us, but why is it only happening now that things are settled? The huge popularity of multi-asset funds in recent years is in no small measure thanks to the fear of volatility and the risks it carries. Will managers be just as suspicious of volatility measures when things inevitably become choppy once more?
As Dunatov and others have pointed out, short term volatility should be of little consequence to long term investors. So let’s enjoy this period of calm while it lasts and see it for what it really is: a brief respite from the peaks and troughs of ‘normal’ conditions. Markets will rise and markets will fall, but over time clear patterns can be detected over the noise. It is these long term trends which institutional investors should be concerning themselves with.
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