ETF Focus: Expect ‘elevated volatility’ in ‘the vast majority of U.S. ETFs’ in 2018

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The U.S. stock market was historically quiet in 2017—daily moves were slight, volatility was near record lows, and major indexes have gone a nearly unprecedented length of time without even mild pullbacks.

While that environment has thus far extended into the new year, and the Cboe Volatility Index VIX, +0.33%  neared one of its lowest levels ever on Wednesday, investors shouldn’t expect it to be the new normal going forward.

“Coming off extremely low realized volatility in 2017, the options market is broadly bracing for a pickup in volatility this year,” Goldman Sachs wrote on Thursday. “For 2018, the options market expects volatility in the Dow to rise by the highest percent, joined by high yield [bonds], S&P 500, Consumer and Tech stocks.”

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According to the WSJ Market Data Group, the absolute daily percentage change for the Dow Jones Industrial Average DJIA, +0.56%  was 0.31% in 2017. It was 0.3% for the S&P 500 SPX, +0.45%  , and in both instances, that represents the smallest absolute daily percentage since 1964. For the Nasdaq Composite Index COMP, +0.18% the absolute daily percentage change was 0.44%, the smallest since 1989. The average observed one-month volatility in the S&P 500 was lower than any other year since 1970 in 2017, per data from S&P Dow Jones Indices.

Goldman called low volatility “the defining characteristic of the U.S. equity market in 2017,” and per the firm’s analysis, the S&P 500 had a realized volatility score of 7 in the year, which is “ranked in the first percentile since 1930.” It added that “the risk-adjusted price return of 2.9 ranked in the 97th percentile relative to history.”

In 2018, however, the options market suggests a different environment altogether. According to Goldman, options investors are positioning for the average stock in the S&P 500 to move 22% (either up or down) over the coming 12 months.

While stock volatility is not the same as broad-market volatility—and indeed, low correlations has been cited as a primary factor behind the market’s lack of sharp gyrations—Goldman expects both to see a pickup. For the market overall, expects this to manifest itself in the trading of exchange-traded funds tied to major indexes like the S&P or the Dow.

“It’s notable that the options market is pricing in elevated volatility levels for 2018 for the vast majority of the U.S. ETFs we monitor,” wrote Katherine Fogertey, an options strategist at Goldman.

As an example, Fogertey cited the SPDR Dow Jones Industrial Average ETF Trust DIA, +0.62% which tracks the Dow. The fund “returned 28% last year (on realized volatility of 7) yet the options market is pricing in that the ETF generates less than half of the return in 2018 on double the volatility (11% / 14.3%, respectively),” she wrote.

Similar trends were seen in two major market sectors. The Consumer Discretionary Select Sector SPDR ETF XLY, +0.04%  returned 23% last year, with realized volatility of 8%, “generating among the highest Sharpe ratios in our universe,” Goldman wrote. Going forward, “Option investors are pricing in that the XLY returns +/-13% by January 2019, yet realizes a volatility that is 73% higher than what we saw in 2017.”

Two ETFs tracking the tech sector—the Technology Select Sector SPDR ETF XLK, +0.54%  and the PowerShares QQQ Trust Series 1 QQQ, +0.17%  — “are both pricing in the potential to return substantially less returns in 2018 than in 2017 yet the options market is expecting higher volatility for both.”

Outside of equities, Goldman expects high-yield, sometimes known as junk, bonds to also see elevated volatility,”as well as high level of concern,” compared with last year.

The iShares iBoxx $ High Yield Corporate Bond ETF HYG, +0.11%  “returned 6% last year on a realized volatility of 4. The options market is pricing in the potential for the ETF to trade up or down 7% by January 2019 expiration on a realized vol of 7, double the realized volatility of 2017.”

Counterpoint: Stock-market volatility isn’t going to come roaring back: Morgan Stanley