One week ago, on November 9 something snapped in the Nikkei, which in the span of just over an one hour (from 13:20 to 14:30) crashed more than 800 points (before closing almost unchanged) at the same time as it was revealed that foreigners had just bought a record amount of Japanese stocks the previous month.
As expected, numerous theories emerged shortly after the wild plunge, with explanation from the mundane, i.e., foreigners dumping as the upward momentum abruptly ended, to the "Greek", as gamma and vega stops were hit by various vol-targeting (CTAs, systemic, variable annutities and risk parity) funds. One such explanation came from Deutsche Bank, which attributed the move to a volatility shock, as "heightened volatility appears to have triggered program trades to reduce risk", and catalyzed by a rare swoon in both stocks and bonds, which led to a surge in Nikkei volatility...
... and forced highly leveraged risk parity funds and their peers to quickly delever. As DB's Masao Muraki explained at the time:
[the] increase in stock (or stock and bond) volatility might trigger position cutbacks when hedge funds, CTAs, and others engage in trading with higher leverage. In fact, stocks and bonds weakened from about 13:20 in the Japanese market on 9 November
The involvement of risk-parity funds in the Nikkrash was hardly a surprise, because as we noted in "Global Stock, Bond Selloff Accelerates Amid Risk-Parity Rumblings" risk parity proxies had just suffered their worst day since July:
Risk Parity not having a good day pic.twitter.com/GRdpB4NUOj— zerohedge (@zerohedge) November 10, 2017
In good news for "market stability targeting" central banks around the globe, that moment of sheer risk-parity turmoil was confined to that day, and in a follow up note released today Muraki writes that Japanese equities "have broadly returned to our model as of the 15th (there was a small volatility shock on that day as well)."
This is also confirmed by the performance of risk parity funds, which have rapidly "normalized" in the past few days.
There were some not so good news too, and as the Deutsche strategist wrote, "we will be closely monitoring whether the Japanese stock market returns to moving in tune with US equities, interest rates, and forex, or again diverges." Why? Because with volatility already at or near record lows across most asset classes, vol spikes - recall the beta of spot VIX is now over 19 - will become increasingly greater, leading to even more aggressive "buy the dip" reversals, largely as a result of retail investors entering the vol-selling space:
We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility. There is possibility of greater volatility amplitude than in the past because of the participation of less experienced retail investors along with hedge funds as the traditional sellers of volatility.
And the punchline:
Funds with volatility targeting strategy are growing to the largest ever. If the influence of such funds expands, the buying pressure on risk assets would increase in low volatility phase, and the selling pressure would increase in high volatility phase.
The conditional framing of that statement was redundant, because as DB also shows both Var. Annuity and CTA funds have been growing by leaps and bounds in recent years, and while there is no definitive size for the risk parity universe, we do know that roughly half of the world's biggest hedge fund is one giant risk-parity strategy. It is not alone. In other words, the "influence" of vol-targeting funds has never been greater, and it continues to grow with every passing day.
Meanwhile, even more troubling, the leverage of an indicative vol-targeting fund (with a 12% vol target) likewise continues to grow, meaning that any vol spike could have devastating consequences for the fund, and the market, as it would be virtually impossible to deleverage in time.
Which means that as the DB thesis plays out, the swings in the market will continue to get increasingly bigger.
And while in the good old days one would be able to at least hedge partially by buying VIX futs or calls, now it is the vol complex itself that is suppressed, making hedging not only impossible but assuring that future vol surge episodes will be even sharper, faster and more acute.