Portfolio Stress-Test I: Prepared for Volatility Shocks?

Portfolio Stress-Test I: Prepared for Volatility Shocks?

For a long time, the financial press has been awash with the historically low levels of volatility that markets have exhibited over the last few years. The prolonged appreciation of equity markets paired with extremely low interest rates has ‘motivated’ investors to retain high equity exposure. Consequently, investors have become increasingly complacent and pay less frequent attention to the rebalancing of their portfolios.

A popular gauge of stock market volatility is the CBOE Volatility Index, VIX, which indicates the market expectation of 30-day volatility. VIX is constructed from the implied volatilities of a range of S&P 500 index options (calls and puts). It is a forward-looking volatility measure of the U.S. market and it is often referred to as the ‘fear index’.

To give some detail on VIX levels, we note that the close of VIX on January 31st was 13.54, while the close of the S&P500 index on the same day was a whopping 2,823. In contrast, on February 5th, the VIX index spiked by 115%, whilst the S&P500 index fell 4%, in effect erasing this year’s profits in a single session.

Does this re-emergence of volatility and lower stock index levels imply that the stock market is led to an imminent reckoning towards the next financial crisis? Should investors now rush to reallocate capital away from U.S. equities, into other asset classes or into cash, in an effort to weather the inevitable market turbulence and ultimately preserve their capital?

In multi-factor dynamical systems, such as the financial markets, a single number is very rarely the sole driver of a system’s emerging behavior. However, investors should not wait for extreme values to test their portfolio ‘endurance’ or lack thereof. Instead, each portfolio factor, such as the price volatility, should be continuously monitored so that an investor can assess the effects of any variations of that metric to the portfolio’s overall risk profile.

In brief, do investors understand the effect of a violent volatility increase or decrease on their portfolio risk level? What would the behavior of a multi-asset-class portfolio be, should stock market volatility increased by 100% in a single day?

Stress-testing methodologies allow us to gauge a portfolio’s behavior in different scenarios, like high volatility versus low volatility regimes. This way, the investor can view the risk decomposition of the portfolio by asset class and effectively identify and rectify any ‘imbalances’ between weights and risk. For example, if investors identify asset classes with low portfolio weights but which contribute greatly to the overall portfolio risk, they could rebalance or remove that asset classes.

Such a simulation analysis is designed to determine how certain stressors on given factors can affect a portfolio’s ability to deal with unexpected market events. Following that same logic, an investor can stress-test every factor used in a portfolio, for a series of different ‘stressed’ values, to create hedging or defensive rebalancing scenarios for a spectrum of shocks.

Stress-testing is not only useful in measuring market risk. Regulatory stress-testing under various crisis scenarios can help determine portfolio risk and set hedging strategies to mitigate potential losses. Retirement and insurance portfolios should also use stress-testing analysis to ensure that unexpected events would still allow them to maintain efficient stream of cash flows and payout levels for their clients.



About KlarityRisk

KlarityRisk is an award-winning software provider that specializes in market risk analytics and compliance risk reporting solutions for the buy-side sector. KlarityRisk is an SS&C Advent partner and its solutions are natively integrated with Advent Geneva, APX, and AXYS. Guest author, Makis Ioannou, is the CEO of KlarityRisk; the views and opinions expressed in this blog post are those of the author and do not necessarily reflect those of SS&C Advent.

To learn more about KlarityRisk contact info@klarityrisk.com.