Capturing contrarian opportunities in a low-vol world
Volatility has generally been subdued this year and the VIX index recently touched lows not seen since early 2007. It’s unclear as to why volatility has been so low in recent months given President Trump’s tumultuous opening months in office, combined with potentially high-stake European elections. Indeed most investors can be forgiven for expecting 2017 to be a year of heightened volatility.
So what is calming markets? Benign macro-economic conditions and dampening effects of central bank policy are potential factors, but we fear investor complacency could be playing a big part.
Is the market primed for surprise risk?
Despite the upward trend in markets, we are seeing signs of investor caution. Cash levels are reasonably high and many investors worry valuations are beginning to look quite stretched, especially in the US.
Low readings of volatility gauges like the VIX and VSTOXX (the European ‘fear’ index) could be further signs of imminent risk. For example, days after the VIX dipped below 10 in early May, US markets lurched downwards, recording their worst day in eight months. The two other occasions when the VIX fell below 10 preceded a bond market sell-off in 1994 and the global financial crisis. In a market where we are finding many stock valuations quite demanding, finding exposure to volatility seems to be an interesting contrarian theme for us.
How to play current volatility?
As an equities strategy, how do we play this contrarian theme? Within financials, there are a number of companies that rely on volatility to drive trading volumes. The investment banks have recently enjoyed a flurry of activity on the back of the ‘Trump bump’. However, these companies generally do not meet our quality criteria. There are simply too many balance sheet risks, including high levels of leverage and opaque hard-to-value balance sheets. In times of stress and volatile markets, we feel these would be particularly risky investments.
Pure trading businesses like exchanges, market makers and inter-dealer brokers are attractive as they combine strong returns, high levels of cash generation with exposure to volatility-driven trading activity. IG Group, the leading provider in spread betting and CFD products, is generally geared to volatility in the short term. While regulation is a key risk, IG is best positioned to adapt to the changing environment at the expense of smaller players.
Flow Traders: valuation unreflective of potential
Flow Traders is another interesting play on volatility. It is a leading ETF market maker with c.20% of market share in Europe. Taking a long-term perspective, it is benefitting from the structural growth in ETFs; in the short term, its revenues are largely influenced by volatility. When this is subdued, low trading volumes and tight spreads weigh on revenues. However in times of stress or market dislocation, volatility provides a kicker to its structural revenue growth.
We believe this is an interesting way of playing volatility. As well as delivering superior returns and cash, the business is well positioned for structural growth in ETFs, but earnings are currently depressed because of the lack of volatility. The shares have been weak as a result, but we believe there could be significant upside if volatility returns to more normal levels. We believe Flow Trader’s valuation is reflecting the unlikely scenario that current low levels of volatility will continue for years to come.
Calm before the storm
We are contrarian investors so our instinct is to be more cautious when markets are grinding up. In his book, The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb points out that “the feeling of the safety reaches its maximum when risk is at its highest”. While we have little or no visibility as to when volatility will pick up, we feel, over our long-term time horizon, it will normalise to the benefit of companies like Flow Traders.
For this reason, we have been searching for other out-of-favour businesses which are exposed to similar themes while also trimming positions in our asset manager holdings which may suffer in choppy markets. We are used to finding ideas in out of favour themes in anticipation of a rebound. In Flow Traders, we are investing in a business with strong long term prospects, but one which will also perform in volatile markets.
Mike Clements, head of European Equities at SYZ Asset Management