Volatility as a driver of future returns

Given the current level of stress, we thought it would be a good time to share some research. Hopefully we will show, i) this price action is very rare ii) things will eventually normalise iii) there is a positive correlation between volatility and future returns and iv) investors should see the benefits of a long term buy and hold strategy. (Especially one with exceptional companies, which have a very robust selection process)

This price action is very rare.

Last night the VIX (Cboe volatility Index) closed above 75. Looking at the last 20 years, this has only happened on 4 out of the 5181 business days. This gives an indication of the current stress in the market. This has not been sustainable.

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Does the VIX level give any information about future returns?

The table below shows the average total return for the S&P500 for various holding periods (1month- 24month) when the VIX was over a given threshold. It also shows the number of daily observations when the VIX was above this threshold out of the total sample of 5181 business days (just over 20years). For example there have been 5118 days or 99% of the time the VIX has been over 10. This gives the average total return for the market for various holding periods from 1999. (Roughly 7.4%/year) As we can see the average 12 month return increases with the level of VIX at the investment date. For example the average return for a 12month S&P500 investment when the VIX was greater than 20 was 11.3%. We can see very clearly that for the longer term investor, the case to add when vol/VIX is high is very clear.

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At the current level of extreme rare volatility the returns accelerate. At shorter holding periods, there could be more volatility and further losses in the short run as the event unravels (see highlighted 3m returns) however there is a compelling case for investors to remain disciplined and those who have the ability add to long term investments over the next few months do so.

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As you will know we only invest in very rare exceptional companies which are all highly liquid, and have very robust income streams. Our first level of protection to exogenous event risk is robust stock selection and portfolio creation. Therefore although we are 100% long equity at the moment, we are currently experiencing daily -ve returns around 60-70% of the market (Msci World and S&P500).

By Mark Ellis, CEO Nutshell Asset Management

13th March 2020