We may be experiencing one of the fastest and deepest financial crises ever. As a result, the word “unprecedented” has never before been used so often in the financial context. Yet, even in the midst of a global pandemic and its humbling consequences, the pattern of the market fallout has not been at all surprising in our view.
When the coronavirus crisis spilled over to Europe and the global lockdown and its consequences became seen as inevitable, one of the fastest ever sell-offs ensued. Not only was the decline rapid and extremely volatile, but also, unlike 2008, markets were rattled by hitherto unseen volatility-of-volatility levels. For instance, March will go on record as the month with the most SPX limit-down and limit-up trading halts in history. By early April, we had already experienced a relief bull market too.
To make matters worse, liquidity dried up quickly, affecting not only illiquid assets and those traded over-the-counter (OTC), but also listed equities, large ETFs and government bonds. With the traditional short-term and sell-side liquidity providers taken out by regulation, markets remain structurally very shallow, and central banks are now the main driver of liquidity.
Volatility of volatility: the new fear index
In 2019, we wrote a volatility outlook piece where we advised readers not to dismiss the 2018 volatility spike as a one-off. We compared the market dynamic to a game of musical chairs where any reduction in central bank liquidity (the music) could result in a severe correction, with the next most vulnerable investment or investor potentially missing out on one of the remaining chairs. We also argued that the effect of the music stopping could be worse in an overextended economic cycle, when there are fundamentally fewer chairs.
In their decade-long quest to control deflation, global monetary authorities had inadvertently created an imbalance in the volatility of volatility. If the volatility market is relatively stable, markets’ ability to forecast the near future is good. But, if volatility itself is volatile, market visibility becomes murky and, if market liquidity is also shallow, flash crashes can become the norm. Following several risk-on/risk-off waves, the CBOE VVIX (volatility of VIX Index) became known as the new “fear index”, claiming the title from its less volatile and better-known predecessor the VIX.
Volmageddon scenario for UK pension schemes
In 2020, the simultaneous fall in equities and bond yields has created the perfect storm for UK pension schemes, which have been hit on both sides of their balance sheets: assets have dropped while liabilities have been revised upward.
According to Pension Protection Fund data, the aggregate deficit of the 5,422 schemes in the PPF 7800 Index is estimated to have increased to £135.9 billion at the end of March 2020, from an aggregate surplus of £22.1 billion at the end of April 2019, reducing the funding ratio from 101.4% to 92.5% over the last 12 months.
The problem may not be resolved in the near term, as “lower-for-longer” interest-rate policies could have lasting effects on both the assets and liabilities of pension schemes, given that funding levels are highly sensitive to real bond yields.
To hedge or not to hedge: that is still the question
As always, when it comes to hedging, there is no clear-cut answer. Hedging market corrections using popular methods may be both expensive and ineffective at this stage: just because volatility is high, it doesn’t mean it’s expensive, and when it’s low, it doesn’t mean it’s cheap.
Given the tug-of-war between data releases pointing to recession and waves of monetary and fiscal intervention, volatility is likely to remain volatile. We would point out that a valid alternative to market timing exists by overlaying a line of defence to existing portfolios in order to improve their overall risk/return profiles and ride the waves of volatility.
Such a defensive overlay solution should combine different hedging and financing strategies, allowing it to be flexible and to adapt to the market and volatility environment.
Another advantage is the overlay concept itself, which means that the hedging instrument is simply placed on top of an existing strategy. This means there is no need to take anything out of portfolios, and the hedge can be easily customised thanks to the use of cash-efficient, listed and highly liquid instruments.
In conclusion, these solutions allow investors to maintain control of their asset allocation but also create a cushion against further downside risk, before the music stops again.
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