Over the last 18 months, the Invesco Multi Asset team has maintained that the lack of volatility in several markets versus historical norms was providing interesting investment opportunities. At the start of the year, we published a blog reinforcing our belief that volatility was an undervalued asset class (Investing in Volatility: Is Asian Volatility Poised to Rise?) and specifically addressed Asian equity market volatility and how the region’s fundamentals appeared to be pointing toward a storm on the horizon. In the last several weeks, that storm has blown in — we have not only seen a resurgence of volatility in many equity markets, but we have also, once again, seen signs that yesterday’s playbook with respect to portfolio diversification may not apply in the current market regime.

‘Safe haven’ assets are acting more like equities …

Markets began their tumultuous journey downward toward the end of June, driven by déjà vu worthy headlines around Greek debt and exacerbated by familiar fears over a Chinese slowdown and hard landing. During this period Asian equity markets were particularly hard hit, with the Hang Seng China Enterprises Index (HSCEI) falling 38.5% from its peak in May, for example.

To offset the impact from falling equity markets, investors often look toward “safe haven” assets such as government bonds and exposure to the US dollar, and may also shift their preference to defensive stocks versus cyclicals, and to US markets versus their riskier counterparts. However, most recently we have seen correlations rise between equities and the traditional perceived “safe haven” assets of government bonds and the US dollar, indicating their ability to diversify portfolios during periods of equity market stress is being challenged.

… but volatility may help provide diversification

Historically, volatility has been a strong positive performer in the face of significantly falling equity markets. For this reason, we believe that volatility can be an effective tool for multi-asset portfolios, especially in a market environment where conventional asset allocation wisdom with regards to “safe haven” assets is being challenged.

Recently, we saw Chinese equity volatility, measured using an HSCEI three-month volatility instrument, spike from a relatively benign level in the mid-20s, where it had rested for most of the year, to above 52 at the start of September. This movement was exacerbated by large market players, such as investment banks, quickly becoming buyers of volatility instruments. Those who capitalized on the strong move in Chinese equity volatility were able to help offset the drawdown felt by exposure to Chinese or related equity markets during the sell-off.