An uptick in stock market turbulence threatens to disrupt an investing strategy that depends on market stability. Volatility-based funds, in which asset managers like Vanguard group and large insurers have placed multi-billion dollar bets, could potentially worsen the market's decline as they unload their equity positions. Volatility-targeted funds have a major influence on the stock market, given they manage an estimated $400 billion in assets, as outlined in a detailed report from The Wall Street Journal.

What You Need to Know About Volatility-Targeting Funds

  • Volatility-based funds generally buy up riskier assets like stocks during calmer periods, betting billions of dollars that equities will move higher
  • Volatility-targeting funds have an estimated 44% exposure to equities, the highest level in more than seven months
  • In early October, before the Q4 sell-off, these funds had a more than 60% exposure to equities
  • Volatility-targeting funds sold about $10 billion in equities last Thursday, bringing their exposure down to 41%
  • CBOE Volatility Index fell 16% on Friday, jumped 28% on Monday

Source: The Wall Street Journal

Volatility-based funds generally buy up riskier assets like stocks during calmer periods, betting on the market to run higher so that they can reap healthy returns. When turbulence hits, volatility funds scramble to get rid of their equity positions, reallocating funds into historically safer asset classes like Treasuries.

‘You Can Get Easily Whipsawed’ Says Portfolio Manager

“If the next spike [in volatility] is higher, then you’ll see a more extended downmarket and we’d remove equities. You can get easily whipsawed,” said Duy Nguyen, a portfolio manager and chief investment officer of Invesco Solutions. The investor helps manage volatility-based strategies.

On average, volatility-targeting funds have an estimated 44% exposure to equities. These funds’ exposure to stocks is at the highest level in more than seven months, according to Pravit Chintawongvanich, an equity derivatives strategist at Wells Fargo Securities, as cited by the WSJ.

Volatility-Based Funds Double Down on Stocks During Quiet Period

Due to the quiet nature of the markets thus far in 2019, in which the S&P 500 has regained a great deal of the fourth quarter’s losses and flirted with new highs, these funds are particularly loaded up on stocks. This is a red flag for some market watchers who argue that some of 2018’s worst selloffs were exacerbated by volatility-targeting funds. In early October, these funds had a more than 60% exposure to equities, per Wells Fargo.

Chintawongvanich estimates that volatility-targeting funds dumped roughly $10 billion in stocks in one day following market turbulence earlier this month, bringing their exposure down to 41%.

Don't Fear Mild Turbulence

While a wave of volatility could shock the market given the size of investment in volatility-targeting funds, small bouts of turbulence could actually translate into gains for some money managers. This is because many of these funds tend to target stocks that have a lower level of volatility than the broader market, per the WSJ.

Meanwhile, few analysts are forecasting an imminent market downturn or economic recession, as U.S. economic data has supported the thesis of sustained growth. Low inflation and a more dovish Fed is also working in the market’s favor.

Despite the positive indicators, volatility bit back again to start the week. The Cboe Volatility Index, or VIX, after falling 15% on Friday, jumped another 28% on Monday morning as investor jitters grow on fears of U.S.-China trade tensions.

Looking Ahead

As macroeconomic uncertainty remains, investors should buckle up for a bumpy ride ahead. Critics of volatility-driven funds argue that they have significantly altered the market's natural tendencies and are behind the market's recent sharp turns and 2017's historic stretch of tranquility, per the Journal.

“You can see these funds moving together,” said Damian McIntyre, a portfolio manager at Federated Investors. "That can exacerbate any selloff and add a couple percentage points to the pullback," he added.