Tag Archives: VIX

Goodhart’s Law

Goodhart's LawGuest post by Leo Chen, Guest Contributor to Cumberland Advisors.

Goodhart’s Law

“When a measure becomes a target, it ceases to be a good measure.”

-Charles Goodhart

When it was first introduced in 1975, Goodhart’s Law focused mainly on social and economic measures. Since then, many financial market indicators have lost their forecasting power and succumbed to Goodhart’s Law. Nevertheless, Goodhart’s Law in no way depreciates the value and importance of market indicators; it simply means that investors are unlikely to be able to consistently generate abnormal returns over time using popular measures that are publicly available to the entire market. A clear example is what has happened to the CBOE Volatility Index, or VIX.

The Volatility Index

The Volatility Index (VIX) was a groundbreaking product when the Chicago Board Options Exchange (CBOE) released it in 1993. Also referred to as the fear index, VIX measures the expected underlying volatility in the S&P 500 over the next 30-day period on a real-time basis. Using various measures of VIX such as the two-week mean, the 30-day rolling standard deviation, etc., VIX traders and portfolio managers developed strategies that were initially profitable. However, over time it has become extremely difficult to profitably forecast the market by simply observing the movement in VIX.

While the history of the VIX demonstrates how a market gauge lost its predictive power once it caught investors’ attention, the CBOE Low Volatility Index, LOVOL, provides an even better illustration of how an indicator can lose its forward-looking power very quickly. CBOE began calculating the Low Volatility Index on March 21, 2006, and started disseminating LOVOL data on November 30, 2012. The forecasting ability of LOVOL immediately plunged to almost zero within a month. In fact, Goodhart’s Law has captured nearly all of the CBOE volatility indexes as prisoners. These fallen angels are no longer useful tools for forecasting purposes.

Another prominent index, developed in the late 1960s, that uses extremes in its value to signal that a market may soon change direction is the Arms Index (TRIN). As predicted by Goodhart’s Law, while technical indicators such as TRIN were able to successfully predict market returns in the past, their loss of forecasting power was only a matter of time when every technician used these ratios for trading purposes. Even the Federal Reserve was no exception. The pre-FOMC announcement drift was found to explain the equity premium puzzle in 2011. But this 24-hour window disappeared soon after the research was published.

Investors Beware

On one hand, Goodhart’s Law teaches us that a smart investor should not rely on any single factor known by the general public to be “powerful”; on the other hand, it does not negate the significance of any indicator.

The following figure is a ratio brought up by Chairman and Chief Investment Officer David Kotok of Cumberland Advisors. The CBOE SKEW Index measures S&P 500 tail risk, while the VXTH Index hedges “black swan” events such as Black Monday in 1987. Lagging and scaling both indexes by the lagged VIX, we are able to track the daily SPX with a correlation that can top 90%, comparable to the correlation between the S&P 500 and GDP. Nonetheless, a high correlation is not necessarily equivalent to strong forecasting power. While one could use this chart for long-term investing strategy, the accuracy of using these daily ratios to predict the daily market movement is approximately 51%, not economically significant enough for forecasting purpose.


Figure 1. Correlations between SPX and Volatility Indexes


The list of captives of Goodhart’s Law is clearly longer than just the indicators mentioned above. High-quality research should be able to produce positive abnormal returns as long as there is information that can be exploited; however, superior research alone is no longer synonymous with outperformance – time is also of the essence. Because of technological innovation in financial markets, the time frame in which Goodhart’s law operates today is much shorter than it was in earlier decades. Just as Moore’s Law predicts that chip performance will double every 18 months, investing methodologies must continually evolve in order to remain profitable, due to Goodhart’s Law.


The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with Folio Investing or The Portfolioist.

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Beyond VIX: The Outlook for Market Risk

A couple of notable statistics pertaining to current market conditions are VIX and implied volatility numbers for the S&P 500 and other major market indexes.  For those who are not familiar with these measures, they are ways to quantify risk.  Implied volatility is the market’s consensus view of risk.  VIX is an index that tracks very near-term implied volatility.  There is a great deal that we can see in the market by looking at these numbers.

The trailing 3-month volatility of SPY (an S&P 500 ETF) is below 12% and VIX is at 16.3 (16.3%) as I write this.  The trailing 1-year volatility for SPY is 22.7%.  Market volatility in the last several months has been very low.

Now let’s look forward.

There are several major market indexes that are worth watching.  Continue reading

Q3 2011: Another Test for 2010 Target Date Funds

The third quarter of 2011 was impressively bad.  The S&P 500 Index lost 13.9% for the quarter.  The VIX, the standard measure of market volatility, repeatedly closed above 40 during this quarter. To put this in perspective, the average daily closing value of VIX from the start of 1990 through the end of September 2011 was 20.5. The average daily closing value for VIX during Q3 of 2011 was 30.6. 

Many critics of Target Date funds felt that these funds lost too much during the bear market in 2008. Special attention was focused on 2010 Target Date funds, funds designed for investors planning to retire in 2010. The poor performance of these funds even got the attention of the SEC, which proposed new disclosure standards. Market observers (including the SEC) noted that 2010 Target Date mutual funds lost an average of 24% in 2008. In light of 2008, many funds redesigned their asset allocations to be more resistant to massive market declines. 

Now, let’s flash forward three years. Continue reading

When Market Volatility Returns with a Vengeance

Wall Street has a bad case of the downers lately. With triple-digit drops in the Dow one day and double digit jumps the next many investors chose to take shelter on the sidelines as they pried open a bottle of Pepto.

The picture is not pretty: As of August 10th, investors could only stand back and watch as the S&P 500 Index continued a 20-day trading sell-off resulting in a 14% loss. So what does it mean and what should we do about it when the market as a whole suggests that the value of a broad index of U.S. companies is 14% less today than a month ago?
Continue reading

Jeremy Siegel says we are in a ‘bond bubble’

Jeremy Siegel, Wharton professor and author of well-known Stocks For The Long Run, published an article this week in the Wall St. Journal saying that we are in a bond bubble.  Bubbles are periods of irrational price appreciation in an asset class, followed by a return to rationality when everyone heads for the door and sells.  With yields from government bonds at multi-decade lows, this is hardly a risky call. Continue reading

Volatility, Efficient Markets and Human Behavior

In an earlier post, I quoted testimony given May 20 before a subcommittee of the Senate Committee on Banking, Housing and Urban Affairs about the “flash crash” rapid market drop of May 6. There  Larry Liebowitz, Chief Operating Officer of NYSE Euronext argued that with modern technology “fear gets transferred to the market faster than ever.”  Is that the market being super efficient? Not really. Fear is an emotion, a human behavior, not information about the underlying investments. Continue reading