Volatility is Good (or at Least it Can Be)

It is conventional in finance to conflate risk and volatility. And, by definition, this makes volatility bad. This association is a dramatic oversimplification.

Opposing this, there is the popular assertion that “high risk, high reward” is true. This is also a dramatic oversimplification.

As with everything interesting, the truth is nuanced. In a static investment, volatility is bad. It is just noise that you aren’t compensated for. This is risk with no reward. In fact, many studies show that leveraged positions in low volatility stocks outperform high volatility stocks (See Footnote¹). High risk generally leads to low reward as well as the obvious danger that a high degree of randomness brings to a portfolio. The fact that risk is bad isn’t news in most parts of life. Performing brain surgery as a hobby is very risky, and the rewards are very poor.

For a buy-and-hold investor, high volatility is associated with poor returns, bigger drawdowns and difficulty in distinguishing edge from noise. If you are passive, volatility is bad.

But things are very different when actively investing. 

More Volatility Means More Opportunity

Volatility and time are intrinsically linked. The normal way to think about volatility is that it measures how much a stock fluctuates in a given time. But it can also be expressed in terms of the time it takes the stock to cover a certain range. This isn’t just an aid to intuition; it is a mathematically rigorous equivalence. Informally, volatility is meaningless unless it has time to act. 

In this interpretation, high volatility means that time slows down. More movement taking place in a given time is equivalent to the movement taking place in a shorter time. If you are actively trading and have a valid edge, this is a good thing. You get to do more trades. And doing more trades can make more money (of course, if you have a negative edge, doing more trades will hurt you and you will lose money). If you are card-counting at a blackjack table, you want to find the fastest dealer you can. A dealer who deals 100 hands an hour should make you twice as much money as one who can only deal 50 hands an hour. Beginning counters find fast dealers difficult to keep up with but, for a competent professional, speed is a way to leverage edge. This same effect and response exists in the markets. 

High volatility can scare many active investors. Things move too fast for them and, before a decision has been reached, the market has moved on. Opportunities are there but can be too hard to capture. But for experienced active investors, high volatility just means they have more opportunities. And by reducing the size of each trade, they needn’t have more risk. 

Surprisingly, this applies to almost all forms of active investing—even those that would seem to be hurt by volatility. For example, in theory, market makers want the market to not move at all so they can buy at the bid and sell at the offer while never accumulating inventory. When a stock moves, they initially lose money as they accumulate inventory with little opportunity to unload. But after the initial shock, volatility helps. The spread widens, and they get to do a lot of trades with this increased edge. Stock-pickers are helped by volatility. If nothing is moving, it doesn’t matter how good your picks are because, well, nothing is moving. But high volatility tends to also increase the dispersion of stock returns. This makes the ability to find good stocks much more valuable.

HTUS Does Well in High-Volatility Markets 

Similarly, market-timing ability becomes more valuable. Any signal that takes you away from the benchmark can translate into a higher dollar difference in a high-volatility environment. Any edge is magnified. Of course, this only works if you have a real market timing edge. Trading a negative edge more often will lead to even worse performance. Volatility isn’t an edge in itself. It is an edge multiplier.

This would be true even if the predictive ability of the signals did not depend on volatility. But about half of our model’s 30 signals do better as volatility increases. Since 2022, when HTUS was reweighed to have the S&P 500 Index as a benchmark, the ETF has done much better in high-volatility environments. When the VIX is above its long-term average, HTUS has outperformed the benchmark by about 11% a year. When the VIX is below average, HTUS has underperformed by about 1%. 

This isn’t an accident. The signals were designed to do this. When volatility is low and the markets are smooth, it isn’t hard to make money. What is more useful is to have a product that can do well in high-volatility environments. HTUS seeks to be this product.

In conclusion:

• Volatility can hurt buy-and-hold investors.
• High volatility means that active investors can “play more often.”
• Market-timing signals can have more edge at higher volatility.

This is a great time to use a good market-timing strategy. The passive competition will tend to do worse than normal. The number of opportunities to collect edge increases. Predictive signals can have an easier time finding edge.

So don’t just sit there, do something. Consider HTUS.

What is HTUS? 

The Hull Tactical US ETF (HTUS) is an actively managed ETF that aims to seek excess market returns to the S&P 500 Index while keeping volatility at or below the benchmark. 

The Fund employs a systematic approach, combining 30+ indicators to arrive at a daily market exposure. These indicators span a wide range of market factors, including macro, fundamental, sentiment, and technical or market anomaly indicators. Instead of a single, strong signal, these smaller signals are more likely to persist and are robust when combined using sophisticated quantitative modeling and machine learning. 

Why Invest in HTUS?

By leveraging machine learning & artificial intelligence, the ETF seeks to provide investors with a sophisticated, active approach to investing that has traditionally only been available to institutional investors and hedge fund investment vehicles with high minimums and fees. Advisors may consider replacing a portion of their large capitalization U.S. equity exposure with the Hull Tactical US ETF.  

¹  "Baker, M., Bradley, B & Wurgler, J. (2011). Benchmarks as Limits to Arbitrage: Understanding the Low-volatility Anomaly. Financial Analyst Journal 67(1), 40–54

Disclaimer

Carefully consider the Fund’s investment objectives, risk factors, charges, and expenses before investing. This and additional information can be found in the Fund’s prospectus, which may be obtained by visiting www.hulltacticalfunds.com or by calling toll-free 1-844-484-2484. Read the prospectus carefully before investing.  

HTAA, LLC serves as the investment advisor. The Fund is distributed by Northern Lights Distributors, LLC (225 Pictoria Drive, Suite 450, Cincinnati, OH 45246), which is not affiliated with HTAA, LLC.  

About the Hull Tactical US ETF (HTUS) Investment Strategy

HTUS is an actively managed exchange traded fund (ETF) driven by various proprietary analytical investment models that examine current and historical market data to attempt to predict the performance of the S&P 500® Index (the “S&P 500®”), a widely recognized benchmark of U.S. stock market performance that is composed primarily of large-capitalization U.S. issuers. The models deliver investment signals that the Adviser uses to make investment decisions for the Core Equity Replacement Income Generation Hedge Fund Style Research in ETF Wrapper May serve as replacement to portion of client S&P 500 exposure Integrated option strategies designed to generate income Active research with foundations rooted in academia Fund. The investment models used are to anticipate forward market movements and position the Fund to take advantage of these movements. Currently, signals are combined into an ‘ensemble’ array that spans statistical, behavior-sentimental, technical, fundamental, and economic data sources. This combined signal is generated each trading day towards the close of the market and dictates whether the Fund is long/short and the magnitude of position sizing. The Adviser routinely evaluates the performance and impact of each model on the Fund with the goal of realizing a risk/return profile that is superior to that of a buy and hold strategy. 

The use of derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments. These risks include (i) the risk that the counterparty to a derivative transaction may not fulfill its contractual obligations; (ii) risk of mispricing or improper valuation; and (iii) the risk that changes in the value of the derivative may not correlate perfectly with the underlying asset, rate, or index. Derivative prices are highly volatile and may fluctuate substantially during a short period of time. The use of leverage by the Fund, such as borrowing money to purchase securities or the use of options, will cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. The Fund’s investment in fixed income securities is subject to credit risk (the debtor may default) and prepayment risk (an obligation paid early) which could cause its share price and total return to be reduced. Typically, as interest rates rise the value of bond prices will decline and the fund could lose value. 

While the option overlay is intended to improve the Fund’s performance, there is no guarantee that it will do so. Utilizing an option overlay strategy involves the risk that as the buyer of a put or call option, the Fund risks losing the entire premium invested in the option if the Fund does not exercise the option. Also, securities and options traded in over-the-counter markets may trade less frequently and in limited volumes and thus exhibit more volatility and liquidity risk. The Fund is an actively managed ETF and, thus, does not seek to replicate the performance of a specified passive index of securities. The Fund may take short positions. The loss on a short sale is theoretically unlimited. Short sales involve leverage because the Fund borrows securities and then sells them, effectively leveraging its assets. The use of leverage may magnify gains or losses for the Fund. There is no guarantee that any investment strategy will produce positive results. There is no guarantee that distributions will be made.

The thoughts and opinions expressed in the article are solely those of the author. The discussion of individual companies should not be considered a recommendation of such companies by the Fund’s investment adviser. The discussion is designed to provide a reader with an understanding of how the Fund’s investment adviser manages the Fund’s portfolio.

The Advisor has implemented policies and procedures to mitigate potential risks associated with the use of machine learning or artificial intelligence, including development, use of, supervision, and testing of models and algorithms.