February 7, 2022 | macro-economic research report

Research Report: Volatility Returns

BY: Richard Croft
The “picture-is-worth-1,000-words” metaphor is well-suited to illustrate the performance of financial markets during January 2022. Early declines, most notably within the tech heavy Nasdaq 100 index, were followed by sharp rallies, described by pundits as take your pick: a reversion to the mean or a bull fake out. The late-stage rally in the Nasdaq prevented it from recording the worst January in its history.



The “picture-is-worth-1,000-words” metaphor is well-suited to illustrate the performance of financial markets during January 2022. Early declines, most notably within the tech heavy Nasdaq 100 index, were followed by sharp rallies, described by pundits as take your pick: a reversion to the mean or a bull fake out. The late-stage rally in the Nasdaq prevented it from recording the worst January in its history.

Most interesting was the performance of growth versus value stocks as measured by the two iShares Russell 1000 ETFs. There was a notable shift from growth to value in early January as witnessed by the performance of the Dow Jones Industrial Average versus the Nasdaq 100 index.

What makes this poignant is the fact that Growth has been dramatically outperforming value for the past three years (see accompanying chart). Spurred on by low interest rates and central banks’ quantitative easing programs. Given the central banks’ changes in sentiment, value stocks have become more attractive.

We are talking about a massive change in sentiment as central banks have moved away from focusing on economic stimulus to attacking inflation expectations. Analysts expect the U.S. Federal Reserve to raise rates three to seven times during 2022. While we are at the lower range of those forecasts, these increases will have the biggest impact on growth stocks that tend to be more leveraged.

The other factor that plays into the value camp is the fact that global central banks have stated that they will end their quantitative easing programs and, in time, will normalize their positions by allowing bonds held on their balance sheets to mature without engaging in new purchases. This is a dramatic change in sentiment, which should benefit value stocks, most notably financial institutions such as banks and insurance companies.

During such periods, financial markets are susceptible to volatility, giving investment firms skilled in the use of option strategies the opportunity to provide above average risk-adjusted returns for their clients.

The option market measures risk by calculating the market price volatility associated with the underlying security. In simple terms, spikes in volatility lead to higher option premiums, which benefit option writing strategies.

Consider the numbers. Suppose we have an average stock trading at $100 per share and we are selling a three-month call option with a $105 strike. This strategy, referred to as covered call writing, limits the upside to the strike price of the call option. Which is to say, if the stock rises above $105 per share, we are obligated to sell the shares at the $105 strike price, so we forfeit any gains above that level.

On the positive side, we gain downside protection from the sale of the call option. Any premium received offsets the purchase price of the underlying stock. Measuring the benefits of downside protection against upside limitations is the benchmark one must employ to ascertain the appropriate time to utilize the strategy.

In the last quarter of 2021, during which the implied volatility for the average stock was about 30%, we would have received $3.93 in premium from the sale of that hypothetical three-month call option. Today for that same option, we would receive $5.87 in premium income (see accompanying table).

In a growth environment, the limit on potential gains in the underlying investment price is not worth the premium provided by the sale of the call option. In the current environment, where we have above average volatility and the prospect for limited upside, the downside protection afforded by the higher premiums more than offsets any stock price upside limitations.

We think covered call writing, which we employ in several of our proprietary pools, will be the appropriate strategy for 2022. Especially if through the remainder of this year financial markets ebb and flow, ending in single-digit performance attributes, which is the 2022 consensus of many analysts’ estimates.

In summary, the ideal time to employ covered call writing is when the upside price limitations occur in an environment of heightened volatility. Most money managers do not have the expertise to deal in options and prefer to manage risk instead by shifting asset allocations within their clients’ portfolios. The challenge with risk reduction strategies based on asset allocation require increased exposure to fixed income investments such as bonds, which are likely to significantly decline in value in a rising interest rate environment.


In every market there is the potential for black swan events. According to Investopedia, a black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.

So, by definition any ability to anticipate black swan events is questionable. While we can extrapolate certain risks, we cannot know with certainty which may trigger such an event, nor the outcome.

At present, we see two possible black swan events: 1) the potential emergence of a more virulent and more transmissible covid nineteen variant; and 2) the potential for a full-scale invasion of Ukraine by Russia. Both events are recognizable, neither is predetermined and the outcome is uncertain.

The rise of a new variant is a distinct possibility, although most experts believe that while it might be more transmissible than Omicron, will not be any more severe. The big fear is that a variant of concern will emerge from the Olympic games in China. If anything were to get out of the self-imposed Olympic bubble, the consensus view is that the Chinese population will not be able to avoid wide-spread infection.

We know that the Chinese vaccines that do not employ the MRNA protocols are not as effective against serious outcomes. With a zero-covid strategy in a country that houses about one fifth of the world’s population and given, the Chinese population remains very susceptible to breakout waves of Omicron infection.

It is also important to note that, unlike most industrialized countries, the Chinese do not have access to family physicians. Medical assessments occur at local hospitals. This is a country with 1.4 billion people and seven million hospital beds. Any uncontrolled waves of Omicron infection could swamp hospital capacity and disrupt manufacturing, causing additional supply chain challenges prolonging the inflationary impact and delivering a severe impact on financial markets.

The Russian Wildcard

The second potential black swan event is the possible Russian invasion of Ukraine. That President Putin is willing to engage in a perilous political risk on the pretext of protecting its borders from “NATO aggression” displays staunch determination. Whether this is bluster to get the world to listen to his concerns or an attempt to further annex bordering countries that want to forge closer ties with the industrialized world is anyone’s guess.

Whatever the reason, it is a game of high-stakes political poker. Certainly the Russian armed forces are formidable and such a war on the continent will have far reaching consequences, particularly for the European Union. To that point, there are Russian war ships anchored off the coast of Ireland. That may seem an odd place to stake a claim, but that is the area where undersea fiber-optic cables provide communications and Internet links to the European Union. Should Russia choose to destroy those links, the impact would be widespread and could lead to world war.

This does not even account for the risks to the flow of natural gas through a recently completed pipeline that links Russia directly with Germany, bypassing Ukraine. Unfortunately, President Biden’s clean energy policy seriously impinged the U.S. oil industry, which could have been an ace-in-the-hole to offset supply disruptions from Russia.

That said, Putin’s gamble is not without domestic risks. U.S. economic sanctions would decimate the Russian economy if cut off, as threatened, from the Society for Worldwide Interbank Financial Telecommunication (SWIFT).

According to Wikipedia, SWIFT is a Belgian cooperative society that serves as an intermediary and executor of financial transactions between banks worldwide. SWIFT does not facilitate funds transfer: rather, it sends payment orders that are settled by correspondent accounts that institutions have with each other. To exchange banking transactions, each financial institution must have a banking relationship by either being a legally chartered bank or through an affiliation with at least one bank. While SWIFT transports financial messages in a secure manner, it does not hold accounts for its members nor performs any form of clearing or settlement.

There is also a question about whether President Putin’s show of force achieved any of the intended goals. Putin was hoping that a show of force would weaken NATO’s resolve. Instead, it made NATO relevant by creating a scenario – fear of Russian expansion – that is the raison d’être for its existence.

One could also argue that Russia’s annexation of the Crimea brought Ukraine together as a state, which laid the groundwork for its movement towards NATO membership. Before Crimea, Russian sympathisers made up more than 40% of Ukraine’s parliament. Today, that number is closer to 15%. In hindsight, Russia could have managed their external risks by establishing relationships with Ukraine based Russian loyalists.

No doubt Putin will be weighing further blowback against the benefits of an all-out invasion. One would like to think that despite a narrow path to a diplomatic solution, it will become the road of choice. In this scenario, the parties are working with a tight timeline. Military experts expect nothing to happen until after the Olympics and the key that will define a point of action will be when Russia moves additional medical equipment to the front lines. At this stage, all we can hope for is that Putin’s gamble is bluster and not a prelude to war.


There are solid arguments in support of passive (i.e., indexing) and active (asset allocation, sector rotation, growth versus value, etc.) investment management.

Unfortunately, in this debate we usually hear opinions based on the biases of the authors. Rarely do we get to examine one approach versus the other through the lens of an unbiased observer. Within that backdrop that we enter the debate as a firm that utilizes both approaches in the management of client assets.

Purely in terms of statistical analysis, passive investing typically outperforms active management. In any calendar year, 80% of active managers are unable to beat the performance of their benchmark index.

On the other hand, active management has a better track record at risk mitigation strategies during the ebbs and flows of a market cycle. Unless you can frame the discussion within the context of your own investment approach, the debate serves more to confuse than to elucidate.

Allow us to take you on a random walk through both sides of the debate, and hopefully frame indexing versus active management within the context of your personal circumstances. In the end, offering a plan of action that comes down on one side or the other is based on your preferences.

The Performance Debate

At the heart of the passive – active debate, as it should be, is the performance question.  Proponents of indexing provide some long-term statistical evidence that suggests most active money managers cannot beat a passive index consistently. And most of that evidence stands up to the harshest critic.

But in this debate, the statistical references are critical. What most indexers do is create a grid that looks at the performance of the index measured against all actively managed funds and ETFs in a particular category.

If active management were to win out on that basis, then more than half of the active managers would have to beat the index. Looking at any large population of managers, over any period, we would expect – statistically – that half will do pretty good and half not so good.

We have also seen comparisons where passive indexers measure the performance of the “benchmark” index against the average performance of funds in a category. That is a more difficult hurdle statistically, and where you usually see the stat that says, on average, 80% of money managers fail to beat an index over any specific period.

Ideally, good financial advisers help clients select better than average performing actively managed funds in a particular category. If the financial adviser is doing a good job and finding above average funds for your portfolio, then comparing average numbers relative to the index, has no place in the discussion.

Selecting Appropriate Benchmarks

Benchmarks are useful tools if applied properly. We often see clients comparing the performance of their diversified portfolio against equity indexes like say the S&P TSX composite index or the S&P 500 composite index. But that comparison is only appropriate if you are holding a portfolio in which 100% of the assets are in Canadian (S&P TSX Composite Index) or U.S. (S&P 500 Composite Index) stocks.

Most of us hold a portfolio that includes equities as well as other assets like fixed income, commodities, and cash. It is for that reason that we utilize the Real-World portfolio Indexes to measure the performance of a diversified passive portfolio with the client’s actual portfolio. The Real-World Indexes are designed to examine performance metrics based on the risk tolerance of the individual investor (i.e., Conservative, Balanced and Growth).

That allows us to make an apples-to-apples comparison within the context of investors’ risk tolerances.  So compared, and prepared, a Conservative investor will not enter periods of heightened market volatility with an all-equity asset portfolio and need to re-allocate. Panic selling at the wrong time can be very damaging to your pocketbook.

The Cost Debate

The reason most often cited for the performance disparity between passive versus active management is cost. For one thing an index like say the TSX composite index has zero cost. Even when you buy an index fund, or an exchange traded fund (like say the S&P-TSX 60 Index ETF or the S&P Depositary Receipts) the annual management expense ratio (MER) plays a major role in the performance discussion. For example, the S&P-TSX 60 Index ETF has a 10 basis point (0.10%) MER, the S&P Depositary Receipts come in with a 9 basis point (0.09%) MER. Even open-ended index mutual funds have MERs ranging from 50  basis points to 110 basis points (0.5% to 1.1%). The average MER for actively managed equity funds comes in somewhere north of 2% or 200 basis points.

What this means is active managers must also earn the MER to beat the index in their clients’ portfolios. If an actively managed equity fund has a 2% MER, then the manager must earn 2% more than the index each year just to stay even. Over the long term, it is difficult to outperform by that much consistently.

We have no problem with this set of statistics. Our concern is in how the financial press has become fixated on the fees. The rhetoric goes something like this: Index funds have much lower fees than actively managed funds. Lower fees mean more in the pocket of the individual investor, and that must be good. So, index funds make more sense because they have lower costs.

Unfortunately, it is not that straightforward. Investors need to understand that there is more to fund selection than just fees. It is not just about costs and performance, it is about strategy, approach and how a fund fits within your overall portfolio. Plus those fees may pay for other services (financial planning, tax advice etc.) over and above active investment management.

Risk Adjusted Performance Debate

Proponents of active management will tell you that an index fund will rise and fall with the underlying index. No better… no worse. Buy an index fund and you are buying mediocrity. This argument seems hard to accept when the statistics tell us that passive indexing beats most active managers.

However, when you look beneath the surface actively managed funds provide some compelling arguments against settling for mediocrity. The problem is we only see the benefits of many active strategies in a down market.

Index funds are always fully invested in the underlying index. That can exacerbate risk when you consider that 20% of the S&P 500 Index is composed on the five mega tech companies (i.e., Apple, Amazon, Microsoft, Google, and Tesla). We see the same concentration in Canada as the S&P TSX Composite Index has a 30% plus exposure to financials and another 30% to commodities and energy.

Active managers take it a step further by quantifying the relationship between risk and return. They argue that investors should compare the risk adjusted performance of their actively managed portfolio versus the risk adjusted performance of their benchmark index. That statistic supports active management, because actively managed funds win hands down on a risk adjusted basis.

So, by definition active managers often hold a lower risk portfolio because such managers are restricted from holding more than 10% of their portfolio in any one company.

Additionally, active managers tend to hold a percentage of their portfolio in cash. And sometimes that weight can be significant. Cash levels are increased or decreased as markets ebb and flow. This flexibility is an advantage as cash provides a cushion in down markets.

Indexers counter that argument by suggesting that it really comes down to an asset mix call at the portfolio level. They argue that advisors are quite capable of making their own asset mix call, and by doing so, provides the same risk reduction benefit at a lower cost.

Think of it this way. Suppose there are two assets in a portfolio: a Canadian index fund and cash. Is a portfolio that is 65% invested in the S&P-TSX 60 Index and 35% invested in cash really any riskier than a portfolio that has 100% of its assets invested in say an actively managed fund or ETF that at any point in time, might have a 35% cash cushion?

The Style Debate

Active managers spend a lot of time talking about style diversification. Diversify across styles like value, growth, and momentum, and you reduce risk. Over the long term, we are not convinced one style is any better than another.

In the last three years, growth outperformed value by a large margin, which was mostly the result of the out-sized returns generated by stay-at-home momentum stocks in an ultra-low interest rate environment. That will likely change in 2022, as value stocks tend to do better in a rising rate environment when quantitative easing is being unwound.

The idea that each investment style will win at some point in a market cycle is what supports the view that style diversification is good. In theory, if you structure a barbell approach that includes value and growth (growth includes momentum stocks) you hold a reasonably diversified portfolio that should see you through the ups and downs of the economy.

The theory has merit. However, if that concept is so good, why is indexing so bad? When you think about it, the S&P-TSX 60 Index ETF provides exposure to the 60 largest companies on the Toronto Stock Exchange.

Within the S&P-TSX Index ETF you will find value stocks (the banks, the oil sector) and growth companies (i.e., Shopify). If you hold the index, are you not, by definition, participating in a cross-section of investment styles?

When you look at what Canadian equity mutual funds are holding in their portfolios – something we do all the time – you usually find on the list of top ten holdings, companies that are prominent in the S&P-TSX 60 Index ETF. To make the case for buying style diversification in a portfolio of actively managed funds, you must believe that the individual fund managers can select the best value, growth, and momentum stocks within the index.


On a macro basis, the real goal is to have a portfolio that lets you sleep at night. If you are comfortable with your portfolio, you will stay invested for the long term, and by doing that you should meet and exceed your investment objectives.

To that point, passive versus active management comes down to how you view your investment portfolio. If you pay particular attention, as we do, about how securities interact within the portfolio, then you should end up with a strategy that captures the best of both approaches. It should be less volatile and that means you will be less likely to make wholesale changes during a market correction.

If you tend to look at your investment assets on the portfolio level, then you should be more concerned that each component in the portfolio is doing exactly what you expect it to. Which supports our view that you are better off employing a trusted active manager to make the asset mix call and construct an investment portfolio best suited to both your needs and current market conditions.

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Richard Croft, Chairman & CIO

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