Since 2008, Central Banks have flooded worldwide markets with liquidity in order to bail out the financial system and stimulate recovery. At first sight they seem to have succeeded in bringing back stability; however, look just a little closer and this apparent calm equals a rather unstable engineered equilibrium. Whenever such equilibrium is challenged, we have experienced increasingly large risk-on risk-off waves that surely tested investors’ risk tolerance. As was learnt from recent sell-offs: when volatility spikes – and does so violently – there remains no liquidity to take the risk off. This in turn exacerbates short-term price action, forcing the liquidation of speculative positions and triggering spectacular short-term volatility of volatility. Such was the case in 2010, 2011, 2014 and 2015, when the volatility of volatility peak was higher even than in 2008. These market dynamics are closely overseen by Central Banks, which in turn systematically intervene and / or step up their dovish rhetoric when there is a technical over-extension of a sell-off thus causing asset cross-correlation to “melt-up”. Therefore, in their quest to control market volatility, global monetary authorities have not just inflated asset prices but also unbalanced the “volatility of volatility”.
What is volatility?
Volatility is the statistical measure of the dispersion of returns for a given security or market index. It can be measured by using the standard deviation of returns of securities or market indices. Usually, the higher the volatility, the riskier the security: this is because fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the downside while, in up markets, volatility tends to decline gradually.
This development becomes clear when looking at the CBOE VIX volatility index which has emerged as a recognized gauge of market short-term risk aversion by aggregating 1-month-ahead option implied volatilities on the S&P500 equity benchmark. Whilst being rather popular, VIX is not yet an investable index. Its relevance has, however, grown with the increased establishment of a liquid listed derivatives market linked directly to it. VIX future contracts and related exchange traded notes have de-facto opened up volatility trades to the broader investment community and have therefore given volatility the status of an asset class.
Shadow risks
While volatility has always existed in markets, its nature has changed in recent years, meaning that volatility itself has become more volatile and is no longer sustained but seems instead to happen in short-term bouts followed by crashes. While on the one hand, the S&P 500 is registering one of its longest streaks of quiet days with +/-1% moves; on the other, flash crashes, spectacular squeezes and abrupt rotation are becoming the norm. This is because the combination of low volatility and low volumes inevitably forces yield hungry investors into crowded trades.
The “traditional” short-term and sell-side liquidity providers have been forced out of the market through increased regulation such as Basel III or the Dodd-Frank Act. This has resulted in markets becoming structurally shallow, especially in the so-called over-the-counter segments.
Furthermore, overseas contagion risks, resulting from the above are often reflected in the realm of liquidity – which is obvious in a global market where geopolitics and economies are tightly interconnected.
W. Buffett put it well when he assessed: “volatility is not the same thing as risk, and investors who think it is will cost themselves money”.
Volatility Value Trap
Chris Cole from Artemis, who was the first to call today's market a Bull Market in Fear, recently wrote: “The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies are creating a dangerous “shadow convexity” that will fuel the next hyper-crash.” “We are nearing the end of a thirty year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razor’s edge of risk” (Artemis Capital Report Q3 / 2015).
The timing or catalyst for the realization of this scenario outlined by Cole is unclear; it might be useful to go with and paraphrase John Mayard Keynes´ assessment for a date when he said “Markets can remain irrational longer than you can remain solvent”. Equally, “Volatility Can Stay Low(er) Longer than Investors Can Stay Patient”. Low volatility regimes can be prolonged and can ultimately become costly for investors looking to hedge their portfolios. Consolidated behavioral patterns will eventually lead to removal (purchase) of insurance at the worst possible point in time of the financial cycle. Counter-intuitively, it may not be the moment to buy volatility outright and investors ought to be careful about which volatility to buy and which risk(s) to hedge.
Volatility can be the quintessential value trap: these days investors may be attracted by historically cheap levels but can lose substantially when carrying various forms of volatility trades. The main explanation for this phenomenon is that low absolute levels of volatility tend to be associated with expensive levels of volatility relative value, the latter driving up the cost of carry.
There are different measures of volatility relative value:
- Implied vs. realized e.g. the volatility ‘premium’ earned by option sellers
- Long-term vs. short-term e.g. the ‘steepness’ of the implied volatility surface
- Out-of-the-money vs. at-the-money e.g. the ‘skewness’ of the implied volatility surface
By mid-2016, all relative metrics of volatility value entered into expensive territory, even though absolute levels collapsed.
Furthermore, the historical probability of volatility surprises is dramatically lower during quiet regimes, affecting the efficiency of standard hedges. This balancing act between the monetary authorities and the markets and between sentiment and fundamentals will persist, causing volatility lulls like the current one interspersed with periodic bouts.
RDI
“To begin with an analysis of the risk, as opposed to the return, is putting the horse before the cart. Incredibly the return cart has been in front of the horse for so long that nobody even notices that it is an anomaly and highly unusual. Risk is the driver of all returns, so it is sensible to ask what risk is being taken to target these returns and/or what the reward for the risk taken is” (CheckRisk newsletter, Aug 2015).
In the last few years investors have witnessed a rise of Risk Driven Investing (RDI), which focuses on risk management – volatility, loss of capital and funding gaps – rather than benchmarks and allocates assets according to style premia - such as momentum, value, volatility or carry.
Leading institutions have now diversified their portfolios not only by asset class but more and more according to risk class with a focus on top-down asset allocation, risk management and efficient execution and a reduced emphasis on security and manager selection as well as market timing. Andrew Ang used an analogy setting out how it´s about the factors and not the asset labels, about the nutrients and not the food. As a result, risk-control, smart beta and risk premia strategies have also become an industry based on its own worth with an increasingly more mature offering.
How to use volatility
Volatility is definitely a useful element for institutional investors as they overwhelmingly share the same challenges to balance their risk and return portfolios according to tight national regulations. For instance, financial engineering and the use of options allow for investors to modify the distribution of their returns in order to have a higher probability of meeting their investment goals. In this context, UBP introduced the concept of a multi-asset mandate with an embedded end-of-year floor, targeting clients with a known maximum tolerance for calendar or tax year losses.
We believe there is an important distinction between ‘overlay’ and ‘tail-risk’ strategies, as they do not hedge the same risks. Investors need to choose which specific risk they want to hedge and a financing leg may be needed to stay with the hedge. Hedging standard market corrections via popular overlay strategies may be both expensive and ineffective at this stage while a valid alternative exists by going long risky assets together with tail protection. This approach could allow investors to play along market momentum but also set an insurance budget against exceptional events in order to ‘sleep at night’. Finally, as we have highlighted, there is room to finance tail hedges by selling expensive forms of volatility, until a new market regime establishes itself. With such a form of protection, we also aim to answer the new challenges posed by the regime-dependent equity/bond correlation and provide an alternative to balanced or risk-parity funds – which rely heavily on such correlation - thanks to the more stable relationship between equity spot and volatility markets.
At UBP, we mostly use volatility to induce convexity in the portfolio defined as having better upside than downside capture. For example, by introducing equity alternative yield into a portfolio via systematic overwriting of index call options - higher expected return for same risk - or mitigating risk via the dynamic use of option and volatility futures overlays - higher Sharpe ratio or better convexity - around equity investments.
In conclusion, it may be time to stay with equities – given the all-time low fixed income yields – but without taking the full equity (tail) risk – and volatility trades can help to achieve exactly that.
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Tommaso Sanzin
Alternative Solutions - Overlay and Quantitative Strategies
Peter Richters
Head of Sales Central Europe and Nordics