One of the urban legends to have emerged after the February vol explosion is that it was mostly retail investors who got crushed by the record spike in the VIX, which in the process wiped out several vol-shorting ETFs in the span of minutes, vaporising years of accumulate paper profits from being short volatility. While entertaining and overflowing with schadenfreude, this take was also wrong, as countless institutions also found themselves crushed by the events of February 5.
But, as GMO's Ben Inker writes in a fascinating report he published yesterday titled "Is Investing Starting to Get Difficult Again? (I Hope So)", the events of the past decade, ever since central banks took over capital markets and have been, as the current Fed chair admitted, "shorting volatility" whether literally or metaphorically - have meant that most professional and institutional investors had no choice: after all, for those investors targeting a given level of volatility - and thus liquidity and risk - whether through risk parity or otherwise, it has been a license to lever up their exposures significantly, to generally good results.
Vol-targeting became an especially relevant point at a time when investors would aggressively add bonds to their portfolio mix to smooth out volatility, eventually leading to the "risk-parity" asset class in which the interplay of credit and equity risk, vol and return allowed some, like Ray Dalio, to become multibillionaires by creating an entire return category of constantly variable equity and debt components.
More notably, however, this convergence of equity and debt strategies came at an interesting time for risk assets: as Inker writes, "the height of this behavior has not been the last few years, but rather the years leading up to the financial crisis."
"Back then, the “Great Moderation” had many investors convinced that economic downturns simply didn’t happen anymore. This led to the most extreme mispricing of risk that we’ve ever been able to see in financial market history."
And while Greenspan indeed unleashed the "most extreme mispricing of risk" in history, it is the events of the past decade, in which central banks coordinated to prevent the collapse of the financial system as consequence to the last two major bubbles blown by central banks in the prior decade. The result was a bizarre shift in the correlation between stock and bond returns on a monthly basis: while historically these correlations have been positive, averaging a little under 0.2, in the last decade there has seen a profound shift in this relationship, with the correlation dropping to -0.64, with the last five years a still stunningly low -0.55 despite the fact that no bad economic events have actually occurred.
As Inker puts it, "this is actually a monumental shift" and explains:
With a correlation of 0.2, adding bonds to a stock portfolio increases the volatility of a portfolio relative to using cash for your low-risk asset. At -0.55, adding bonds to your portfolio sharply reduces overall portfolio volatility.
Narrowing down the time-frame further, over the last five years adding bonds to a stock portfolio decreased volatility materially, and leveraging up bonds decreased volatility still further. Paradoxically, the more debt one added, the lower the resultant portfolio volatility. To Inker, this bizarre outcome was nothing short of stunning:
Historically, adding an 80% levered bond position to a 60% stock position would have increased overall volatility from 9% to 11%.For the last decade, that 80% bond position would have decreased risk from 9% to 7.6%. This has helped traditional portfolios have lower risk than investors might have expected and has been even more beneficial to those in risk parity or volatility targeting strategies.
Nowhere has the consequence of this phenomenon been more startling than on volatility-targeting strategies, because those portfolios are naturally impacted by both correlations and trailing volatility.
But while we have previously observed this fascinating schism between efficient markets theory and real-world portfolio construction, the "monumental shift" is nowhere more palpable than in the following example from Inker.
Take the example of a rather generic 60%/40% stock/bond portfolio which seeks a middle of the road 10% volatility. Historically, investors needed to lever the portfolio by only 3%, giving portfolio of 62% stocks/41% bonds/-3% cash. This calculus, however, changed extraordinarily in the context of our centrally-planned markets: the chart below shows what this specific portfolio would look like given the conditions of the last five years.
As Inker notes, the leverage has gone from a 3% “why bother” level to a stunning 139%. If the last five years are a reasonable representation of the future, 143%/96%/-139% is the new 60%/40%.
Extrapolating further, if you could expect the same risk premia over cash today as historically normal levels, this would mean the expected return of the portfolio has gone from 3.1% above cash to 7.3% above cash! "While this would indeed be lovely, that’s simply too much of a free lunch to believe" Inker notes, and adds that "if the risk of portfolios has truly dropped in the way that the leverage suggests, you don’t deserve to get paid anything like 7.3%. If risk is going to revert to the longer-term averages, the leveraged portfolio winds up having a volatility of over 20%, so maybe you do “deserve” your 7.3%, but with such a high volatility you will wind up compounding at a much lower rate anyway."
Inker then lashes out with a scathing critique of those who have made a royal mockery of the market:
Free lunches shouldn’t persist in investing. They require counterparties to not only be irrational, but to also have a continual inflow of cash to replenish the economic losses that flow from their poor decisions. Low volatility and favorable correlations should not stably coexist with large ex-ante risk premia. But that statement does not specify which state of the world we are in. Has risk fallen sustainably and risk premia fallen along with it? If so, you will need to lever up to try to earn the kinds of returns that unlevered portfolios used to deliver. Or has the recent “easy” environment been a temporary one that is bound to reverse? My money is on the latter (literally, as well as figuratively).
In other words, in order to hand out nearly a decade of free lunches and pander to idiots, while making markets into a child's game where there is no risk, just return, central bankers became:
- with "a continual inflow of cash to replenish the economic losses from their poor decisions"
That however is changing, and not just because after a decade of artificial conditions, central banks are finally starting to reverse their policies, but for the very simple reason first noted by Hyman Minsky long before he saw everything he predicted put in practice by a few idiot central bankers:
Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economies are all that well-behaved. Stability breeds instability, as Hyman Minsky pointed out 40 years ago. Statistically, we should expect to get periods of relative calm in any natural (or randomly generated) system, and those periods end. But beyond that, the calm itself encourages behaviors that eventually lead to highly volatile outcomes. The very existence of risk parity and volatility targeting strategies creates fragility in the markets in the form of feedback loops. At first, a period of calm will lead to increased leverage, which creates net buying to support markets. But a rise in volatility or shift in correlations can lead to deleveraging and selling pressure just when markets are already shaky.
We saw a tiny glimpse of this on February 5 when, supposedly, the retail investors panicked and blew up equity vol. Well, maybe, but they were just the tip of the iceberg. What happens when the rest of the "professional investing community" finds itself in the same position as retail investors did at the start of March when a out of control feedback loop destroyed in second all those who had been selling vol profitability for years and years?
To Inker, the outcome is merely the end of easy markets, and the return of the far more interesting, and profitable, 'hard markets':
After years of very low volatility and strongly negative correlations, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years. In that world, historically normal risk premia make a lot of sense, and all of our collective investment goals rely on those risk premia remaining similar to historical levels. The trouble is that markets today, particularly US markets, aren’t priced for that world, so if current conditions persist, I believe valuations are likely to fall.
We can either have an easy world, and get paid little for investing, or a hard world where we get paid more. Easy may be more fun in the short run, but give me harder and more profitable any day of the week.
Perhaps he is right; unfortunately if he is right, it also means that the "markets" - in quotation marks on purpose - are so disconnected from reality, that the correction would be cataclysmic. The result would be an indefinite halt of one or all markets as true price discovery mechanisms returned with a vengeance, and were shocked by what they discovered. We just don't know if they would ever reopen.