The Landscape of Risk
Posted on 12/19/2014
This article is sponsored by S&P Dow Jones Indices.
Risk is a complicated thing, and S&P Dow Jones Indices’ experience supporting the VIX® series of volatility measures, its continued work in the arena of low-volatility indices and its conversations with clients regarding risk reduction techniques continue to reveal new things about the way markets and investors can react to – and even control – volatility.
But market volatility is not all there is to it. Which is why S&PDJI recently inaugurated commentary on equity market “dispersion”, a market-wide measure of security-specific risk that can be useful in identifying markets and time periods where there is greater opportunity to add value through security selection.
That risk can be indistinguishable from opportunity is a concept as old as the hills, but it is one that is rarely studied. It turns out that including dispersion as well as volatility in the analysis can have surprising results, particularly when applied to common equity factors such as value, or momentum. SPDJI is pleased to include its latest thinking on the topic in “The Landscape of Risk]”.
J.P. Morgan famously remarked, when asked what the stock market would do, that “it will fluctuate.” It was a safe prediction. No matter how we regulate or manage our markets, volatility frequently roiles them. From a classical point of view, high volatility presents opportunities – the prime example being the predictable increases in both risk and return that result from the application of leverage. Thus by implication in the typical legal disclaimer, an increased opportunity for return is associated with increased risk.
Yet periods accompanying extreme fluctuations in the equity market are more often than not associated with losses. In Section 1, “The Landscape of Risk” examines the negative correlations that emerge between market prices and volatilities of the U.S. equity market. Two themes emerge – first, that market behaviour is fundamentally different during periods of high volatility, and second, that opportunities, if they are present, might be comprehended as simply the chance to purchase equities at a discount.
In Sections 2 and 3, the paper examines the structural composition of market risk via the relationship between the volatilities of individual securities and market benchmarks, and relate each to the other with approximating equations. These equations describe a three-dimensional surface, a “landscape of risk,” which is compared to historical market behavior in Section 4.
Not all crises are the same. Although each major pullback in U.S. equities during the past decade has been characterized by unusually high correlations, the bear markets of the early 2000s were instead accompanied by a large degree of independence among the stocks of different sectors. The results of Section 4 describe the role of correlations in crisis periods and describe the potential evolutions of volatility and stock-to-stock correlation that might accompany the next one.
A second goal of this paper is framed by the notion of seeking opportunity in crisis. This theme emerges in Section 1 in the context of market performance, and in Section 2 is a discussion of the subtleties that arise in applying the same concepts to single securities. In Section 3, the paper introduces the concept of dispersion in order to address these subtleties. In Section 5, the paper attempts to attribute the historical relative performance of equal weight, growth, value, and momentum strategies to changes in U.S. equity dispersion. Finally, in Section 6, the current environment is described.
S&P Dow Jones Indices’ “The Landscape of Risk” white paper can be downloaded here. The Landscape of Risk.