How to profit from a return to volatility

An explosive start to 2018 has punctured a period of unprecedented market calm. 2017 had provided a particularly challenging hunting ground for stock-picking contrarians, as volatility measures hit record lows.

While this momentum-driven market offered opportunity to harvest profit, there was little in the way of alpha-generating ideas. Now the market axis is beginning to shift.

Violent markets enable stock pickers to uncover value when the tide of sentiment draws out. The early dislocation in 2018 could be an early portent of a turbulent year ahead – and a sign the market may ripen for price discovery. For true contrarian investors, fraught markets should be welcome, as they provide the conditions to extract alpha and deliver enhanced long-term returns.

Contrarian conditions

One doesn’t need to go back to the credit crunch to look for favourable contrarian conditions. 2016 had plenty of violent flashpoints for investors. The political world was rocked to its foundations by the Brexit vote; the oil price dived to record lows due to acute price pressure; and, the market was buffeted by aggressive sector  rotations. While one swallow does not make a summer, a sustained return to volatility in 2018 looks increasingly likely. The question is: how can investors profit from the approaching storm?

Within financials we have been reducing our exposure to market-level sensitive stocks, such as asset managers, including Schroders, Ashmore and Aberdeen. These stocks have had a great run, but essentially they are linked in to the overall level of the market and creeping debt. And as valuations and debt levels rise, we believe the investment case for these stocks diminishes.

Consequently, over the last 6-9 months we have been switching our exposure to financial infrastructure firms.  These are stock exchanges and other market participants that would benefit from a pick-up in volatility. Within financials, there are a number of companies that rely on volatility to drive trading volumes, but as active investors, we use a selective lens.

Volatility plays

Investment banks enjoyed a flurry of activity on the back of the ‘Trump bump’; however, these companies generally do not meet our quality criteria. There are simply too many balance sheet risks, including high levels of leverage and opaque hard to value balance sheets. In times of stress and volatile markets, we feel these would be particularly risky investments.

Pure trading businesses like exchanges, market makers and inter-dealer brokers such as TP Icap are attractive as they combine strong returns, high levels of cash generation with exposure to volatility-driven trading activity. IG Group, the leading provider in spread betting and CFD products, is generally geared to volatility in the short term. While regulation is a key risk, IG is best positioned to adapt to the changing environment at the expense of smaller players.

Flow Traders is another interesting play on volatility. It is a leading ETF market maker with c20% of market share in Europe. Over the longer term, it is benefitting from the structural growth in ETFs, but, shorter term, its revenues are largely influenced by volatility.

When this is subdued, low trading volumes and tight spreads weigh on revenues. However in times of stress or market dislocation, volatility provides a kicker to its structural revenue growth. The business model delivers superior returns and cash and is well positioned for the structural growth in ETFs, but earnings are currently depressed because of the lack of volatility. We have capitalised on this price weakness and believe there could be significant upside if volatility returns to more normal levels.

Mike Clements – Head of European Equities – SYZ Asset Management