Why is the Vix index out of sync with the turbulent geopolitical environment?

Three months into 2017 and we have already seen Kraft Heinz attempt to take over Unilever, Article 50 has been triggered and the situation in Syria continues to intensify.

With further European elections on the horizon and interesting developments in North Korea, you would have thought that volatility in markets would have been at an all-time high. So why at the end of March was the Vix index as low as 13.33?

First, we need to consider what the Vix index shows. The Vix index calculates 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. For a rule of thumb, a score above 30 means volatility expectations are high, while a score below 20 means volatility expectations are low.

So, at its current level of 13.33, the Vix is suggesting that the market’s expectations are low. Which begs the question, are we overhyping political events? Has the market become complacent? Or is there a fundamental flaw in the calculation of the Vix index?

There are several reasons why the Vix is currently so low. Firstly, the index normally only spikes at an event or a few weeks prior. On 26 October last year (less than two weeks before the US election) the Vix stood at 14.24, but just nine days later the Index had risen to 22.51.

Secondly, the volatility calculation of the Vix reflects the aggregate volatility of the S&P 500, not the individual constituents. If 50 per cent of the index rose by 5 per cent one day and then fell by 5 per cent the following day continuously for a month, while the remaining 50 per cent of the index did the opposite, then over this one month period, the index would have returned 0 per cent and would have had a volatility of 0 per cent, suggesting that there is no risk at all in the index. However, although the aggregate index risk is low, a daily fall or rise of 5 per cent shows the individual stocks in the index are risky.

The low volatility is down to the stock constituents being uncorrelated. Over the last month, the average implied correlation of the S&P 500 has been 0.315, while over the last three years the average implied correlation has been 0.404. The correlation between stocks in the index is lower than average, which may explain why the Vix index is currently so low.

For a UK investor to gauge the volatility expectations in the UK, it would be more appropriate to analyse the FTSE 100 Implied Volatility index. The VSTOXX index, which measures volatility expectations in Europe, reached its second highest point in five years following the Brexit vote, while at the same time the Vix was only at its fifth highest point in five years. The current political uncertainty surrounds elections in Europe and the potential break-up of the EU as we know it, not the political situation in the US, which could explain why the Vix is so low at present.

There are alternative measures that investors can look at to gauge volatility expectations and investor sentiment. The price of safe heaven assets such as gold, developed market government bonds and currencies such as the dollar or the yen compared to their intrinsic value could be a measure of investor sentiment.

However, there are other factors which can influence the price of these asset classes.
Another measure is the amount of cash held by investors. Throughout 2016 we saw inflows into the IA Money Market and Short Term Money market sectors.

No measure of risk is perfect. The Vix index can provide us with a useful indication of expected volatility in the US, but should not be used in isolation. Whichever measure of risk investors choose to look at, it would be wise to understand its shortcomings and to use it with caution.

Tom Poulter is head of quantitative research at Square Mile