How to stop worrying and embrace market Volatility

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By WisdomTree ETFs
Following one of the most tranquil years in stock market history, volatility came roaring back in late January and early February. Many investors were calling for the inevitable return of volatility in 2018, ourselves included. That said, few foresaw how quickly and how violently that prediction would come to fruition. While there was some debate as to what exactly prompted the pickup in volatility (with everything from inflation to inverse volatility exchange-traded products to the all-encompassing “quants” being blamed), the bottom line is that the spike in the Volatility Index (VIX) left equity investors running for cover.

 

One thing we found interesting was that during the height of the correction, the MSCI Emerging Markets Index outperformed the S&P 500 by almost 150 basis points on the downside, with other emerging market (EM) strategies holding up even better.1 Given that the EM asset class historically has had a standard deviation about 50% higher than that of the S&P, EM investors who may have expected the performance of EM to be worse than that of the U.S. were likely pleasantly surprised.

Valuation’s impact on Beta

The EM outperformance brings to mind a concept that Jeremy Grantham has written about: beta is a critical component of explaining relative performance, but valuation can influence beta. Assets that are more expensive relative to their history may experience volatility above their expected levels (and vice versa). When an asset’s price outruns its fundamentals, a downturn in the market can be disproportionally negative when the music stops.

This is the exact same idea that underpins WisdomTree’s original investment philosophy and why we focus on fundamentals. Regarding those fundamentals, within EM we remain encouraged by corporate earnings and believe that the attractive valuation currently offered by the asset class is being underappreciated. As such, the recent sell-off may have provided us with a live case study that validates the dynamic beta concept.

Using Volatility as a Buy signal

As our Chief Investment Strategist Luciano Siracusano recently noted, when the VIX spikes upward, the following 12 months historically have seen strong returns for the S&P 500. Taking it a step further, while elevated VIX levels have portended good times for U.S. equity investors, EM equity investors have had even greater reason to cheer.

VIX Levels vs. MSCI Emerging Market Index Forward One-Year Returns

VIX vs MSCI EM Scatter

VIX vs MSCI EM Table

Learning to embrace Volatility

On a closing basis, the recent high on the VIX was 37.32, set on February 5. Dating back to 2007, of all 163 instances when the VIX reached levels at least that high, the MSCI Emerging Markets Index had positive returns over the next year on every single occasion—with the average one-year return at 69.9%. While VIX spikes admittedly were clustered around a handful of key events, the results each time were unanimous. The big takeaway from our research? The higher the levels reached by the VIX, the higher the forward returns tended to be for EM.

The tough lesson here for investors is to embrace volatility. Where a rising VIX typically equates to a short-term equity sell-off, EM investors who historically have used the dips as buying opportunities often made out like bandits.

1Bloomberg, for the period 1/26/18–2/8/18.

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