Index Volatility in Perspective

Abstract

As the number of indexes and index-based investment products expands, it is critical for investors to understand relative index volatility. This article discusses the issues to consider when evaluating index risk and shares insights and data from the author’s recent historical index volatility analysis. The research evaluates the risk of index exposure from multiple perspectives—over time and on a relative basis—and encompasses U.S. equity, global equity, U.S. sector, U.S. Treasury, and select commodity market indexes. Specifically, the author explores how time dimension affects perception and assessment of risk, the cyclicality of volatility measures, patterns that may signal a future shift in risk, how index volatility measures trend compared to index return measures, and how index volatility behaves above and below the median, as well as under increasing levels of risk. Based on this research, the author shares several important insights, including the observation that risk can suddenly shift well above median levels for a given index, and those shifts often occur simultaneously across multiple indexes. As a result, significant short-term value changes may occur if portfolios are not modified to reduce risk when the inherent volatility of indexes rises. Alternatively, heightened risk may also present tactical investment opportunities for investors who have an ability to anticipate directional index moves.

TOPICS: VAR and use of alternative risk measures of trading risk, volatility measures, portfolio construction