A Closer Look at Volatility

A Closer Look at Volat­il­ity
Com­bin­ing Low Beta & Cyc­lic­al Strategies

by Al­fred Lee, CFA, CMT, DMS
Vice Pres­id­ent & In­vest­ment Strategist, BMO ET­Fs & Glob­al Struc­tured In­vest­ments
BMO As­set Man­age­ment
al­fred.lee[@]bmo.com

March 2, 2012
Re­cent De­vel­op­ments:

• Equity mar­ket volat­il­ity, as in­dic­ated by the CBOE/S&P Im­plied Volat­il­ity In­dex (VIX), has stead­ily de­clined since early Oc­to­ber of 2011. More sur­pris­ingly, there have been few­er in­tra­day gaps in the trad­ing of the VIX, sug­gest­ing the VIX has been sig­ni­fic­antly less re­act­ive to neg­at­ive head­lines (Chart A). Cur­rently the VIX is trad­ing at 18.43, a fair amount be­low its long-term av­er­age of roughly 20.
• As the VIX is of­ten used to gauge the nervous­ness of in­vestors, its re­cent low read­ings in­dic­ates a nor­mal­iz­a­tion of the mar­ket. Des­pite a second round bail­out for Greece, bet­ter li­quid­ity in the Euro­zone due to the European Cent­ral Bank’s (ECB), Long-term Re­fin­an­cing Op­er­a­tion (LTRO) and its swap agree­ment with five oth­er cent­ral banks, sig­ni­fic­ant risk items re­main to sug­gest that the low level of the VIX is not jus­ti­fied. In­vestors should also keep in mind that volat­il­ity has a tend­ency to re­vert to its mean.
• Though the risk rally could very well con­tin­ue giv­en the second tranche of the LTRO, a closer look at the VIX shows that it has likely bot­tomed. Moreover, meas­ures of the VIX show that its down­side mo­mentum has abated.

Po­ten­tial In­vest­ment Op­por­tun­ity:

• Should volat­il­ity sud­denly in­crease, in­vestors may want to con­sider the BMO Low Volat­il­ity Ca­na­dian Equity ETF (ZLB), which is an ef­fi­cient way for in­vestors to ac­cess Ca­na­dian equit­ies at a lower volat­il­ity than the S&P/TSX Com­pos­ite In­dex (TSX). This ETF can be util­ized as a core po­s­i­tion, as part of an in­vestor’s long-term stra­tegic as­set al­loc­a­tion. In­vestors should also note that low beta stocks have his­tor­ic­ally out­per­formed the mar­ket over the long-term. However, since there are peri­ods when high­er beta equit­ies out­per­form the mar­ket, a more cyc­lic­al ori­ented po­s­i­tion can be tac­tic­ally com­bined with ZLB to po­ten­tially gen­er­ate al­pha in the port­fo­lio.
• Provided that the year to date rally in risk as­sets con­tin­ues and re­cent com­ments by U.S. Fed­er­al Re­serve chair­man Ben Bernanke did not spook the mar­ket, in­vestors may want to tac­tic­ally ro­tate a lim­ited por­tion of their port­fo­lio to some high­er beta areas. This week’s an­nounce­ment of an­oth­er €529.5B (US$712.8B) com­mit­ment in the second tranche of the LTRO could po­ten­tially ex­tend the re­cent rally, provid­ing a fur­ther tail wind. In­vestors that are in­ter­ested in tac­tic­ally in­creas­ing the beta in their port­fo­lio, may want to con­sider our BMO S&P/TSX Equal Weight Glob­al Base Metals In­dex ETF (ZMT).
• Since the an­nounce­ment of the first tranche of the LTRO back on Decem­ber 21, ZMT has gained 10.4% on a total re­turn basis, com­pared to the total re­turn of 8.1% of the S&P/TSX Com­pos­ite In­dex end­ing Feb­ru­ary 29, 2012 (Chart B). Fur­ther­more, cop­per in­vent­or­ies, tracked by the Lon­don Metals Ex­change (LME), re­main at more than two year lows, due to a lack of min­ing activ­ity in 2011 (Chart C). China’s re­cent move to lower its bank’s Re­serve Re­quire­ment Ra­tios (RRR) could also po­ten­tially provide fur­ther up­side mo­mentum in base met­al equit­ies. However, giv­en the many risk items re­main­ing on a macro-eco­nom­ic level, the in­creas­ing sens­it­iv­ity in the VIX and with no fur­ther stim­u­lat­ive meas­ures in place, in­vestors should also con­sider im­ple­ment­ing risk man­age­ment strategies. Trail­ing stop-loss or­ders al­low in­vestors to lim­it their down­side and risk could be fur­ther con­trolled through smal­ler al­loc­a­tions to these areas, which tend to be more sens­it­ive to po­ten­tial wan­ing in­vestor op­tim­ism.

Chart A: The “VIX” Looks to Have Bot­tomed

Source: BMO As­set Man­age­ment Inc., StockCharts.com

Chart B: ZMT has Out­per­formed the TSX Since the An­nounce­ment of LTRO

Source: BMO As­set Man­age­ment Inc., Bloomberg,

Chart C: Cop­per In­vent­or­ies Tracked by LME are at More Than Two Year Lows

Source: BMO As­set Man­age­ment Inc., Bloomberg

*All prices as of mar­ket close Feb­ru­ary 29, 2011 un­less oth­er­wise in­dic­ated.

Dis­claim­er:
Stand­ard & Poor’s® and S&P® are re­gistered trade­marks of Stand­ard & Poor’s Fin­an­cial Ser­vices LLC (“S&P”) and “TSX” is a trade­mark of Toronto Stock Ex­change. These trade­marks have been li­censed for use by BMO As­set Man­age­ment Inc. BMO S&P/TSX Equal Weight Glob­al Base Metals Hedged to CAD In­dex ET is not sponsored, en­dorsed, sold or pro­moted by S&P or Toronto Stock Ex­change, and S&P and Toronto Stock Ex­change make no rep­res­ent­a­tion, war­ranty or con­di­tion re­gard­ing the ad­vis­ab­il­ity of buy­ing, selling or hold­ing units/shares in the BMO S&P/TSX Equal Weight Glob­al Base Metals Hedged to CAD In­dex ETF.

BMO S&P/TSX Equal Weight Glob­al Base Metals In­dex ETF (ZMT), one year re­turn: 5.96% and since in­cep­tion re­turn: -23.38% (In­cep­tion date: Oc­to­ber 20, 2009).

In­form­a­tion, opin­ions and stat­ist­ic­al data con­tained in this re­port were ob­tained or de­rived from sources deemed to be re­li­able, but BMO As­set Man­age­ment Inc. does not rep­res­ent that any such in­form­a­tion, opin­ion or stat­ist­ic­al data is ac­cur­ate or com­plete and they should not be re­lied upon as such. Par­tic­u­lar in­vest­ments and/or trad­ing strategies should be eval­u­ated re­l­at­ive to each in­di­vidu­al’s cir­cum­stances. In­di­vidu­als should seek the ad­vice of pro­fes­sion­als, as ap­pro­pri­ate, re­gard­ing any par­tic­u­lar in­vest­ment.

BMO ET­Fs are man­aged and ad­min­istered by BMO As­set Man­age­ment Inc, an in­vest­ment fund and port­fo­lio man­ager and sep­ar­ate leg­al en­tity from the Bank of Montreal. The in­dic­ated rates of re­turn are the his­tor­ic­al an­nu­al com­pound total re­turns in­clud­ing changes in prices and re­in­vest­ment of all dis­tri­bu­tions and do not take in­to ac­count com­mis­sion charges or in­come taxes pay­able by any unit hold­er that would have re­duced re­turns. Com­mis­sions, man­age­ment fees and ex­penses all may be as­so­ci­ated with in­vest­ments in ex­change-traded funds. Please read the pro­spect­us be­fore in­vest­ing. The funds are not guar­an­teed, their value changes fre­quently and past per­form­ance may not be re­peated