Reasons behind rise in market vulnerability

Recent years had seen relatively higher market volatility. However, many observers would be surprised to know that since 2000, a period widely viewed as encompassing high uncertainty, markets have demonstrated volatility near long-term historical averages, overall.

For example, from 2000 to 2011, the annualised market volatility for MSCI to Europe Australasia and Far East was 19 per cent as measured by standard deviation of returns.

How do the GCC markets measure up?

In general GCC markets exhibit higher risk compared to emerging markets, but GCC markets lack long history and, therefore, we should be cautious before making any definitive conclusions. However, going by the standard metric for risk ie, standard deviation, the near-term risk for GCC markets is lower than long-term risk in line with the trends observed above. The annualised risk for the last two years for S&P GCC index is 15 per cent while the same for the last five years is nearly 25 per cent. Even other risk measures point to the same trend. For example, the maximum drawdown (defined as peak to trough fall) during the last two years was 10 per cent, while the same for the last five years was a staggering 62 per cent.

Are markets as risky now as in the past?

Looking back, market volatility, while certainly the highest most of us can recall, is not at all unprecedented. However, volatility is but one measure of risk. Additional consideration should be given to other measures such as liquidity, leverage employed, and portfolio drawdown.

Are markets now more susceptible?

Even though overall standard deviation is now roughly in line with historic measures, standard deviation is but one measure of risk. Research has shown that markets are more vulnerable now to sudden reversals than earlier.

Why is market vulnerability on the rise?

Studies suggest a number of possible culprits for the rise in market vulnerability. Assets invested in passively managed equity mutual funds and exchange-traded funds (ETFs) have grown steadily in recent years, reaching more than $1 trillion (Dh3.67 trillion) by the end of 2010.

What are other reasons for rise in vulnerability?

The rise in index trading is, of course, only one possible contributor to this phenomenon. A second possible source relates to active mutual funds that are managed against an index benchmark. Research indicates that the level of closet indexing among active managers has been noticeably increasing since around 1995.

Are there other reasons specific to GCC?

For GCC, lack of institutional investors may be contributing to higher risk coupled with low liquidity. Domination of retail trade may also induce behavioural biases contributing to higher risk.

What does increased vulnerability mean?

Whatever the drivers behind the rise in market vulnerability in recent decades, the result is a meaningful decrease in the current ability of investors to diversify risk. This is particularly important for portfolio management because diversification is less effective where there is both increased market volatility, and company-specific volatility. These changes have introduced additional challenges for risk management in equity portfolio construction.

Rodney Sullivan is Head of Publications at CFA Institute and Domluke Da Silva is with CFA Emirates