"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius
- Macro and Credit - Watch out for rising positive correlations
- Macro and Credit - Is inflation back into play?
- Final chart: The downward trend in bond yields has limited insurers' hedging budgets
- Macro and Credit - Watch out for rising positive correlations
"Piece of advice for Central Bankers, rising cross-asset positive correlations and risk parity strategies do not mix well..." - source Macronomics, twitter feed.
It is time we think for the members of the Society of the Friends of Truth to reacquaint themselves with our wise words from our February conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool. You might already be wondering where we are going from there but as a gentle reminder, in our book, rising correlations reduces the benefit from diversification, in the end hitting fund's equity directly. Whereas we have mostly disregarded "diversification" this year we opted to avoid the diversification risk in a NIRP world (putting in jeopardy "balanced funds" with reduced downside protection of the bond buffer component thanks to lower yields) for a much simpler "barbell strategy". Therefore we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that is there was a huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up and apart from the most recent "jittery" Fed induced hiking or not hiking moves, for us this strategy worked out fairly well in 2016.
This is what we wrote in our February long conversation:
"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016In our Society of the Friends of Truth, rising positive correlations are a warning sign and also clearly indicative of central bankers meddling with asset prices. This can be clearly seen in the below CITI chart displaying rising cross-asset correlation and the VIX index:
In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out
We quoted Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:
"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital MarketsThanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment.
Furthermore, there are some more indications of some other strategies being directly threatened by central banks intervention and rising positive correlations which could lead to some nasty non-linear price movements and VaR shocks we think.
This clearly the case for Volatility Control Products as indicated by Deutsche Bank in their Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions":
"One year later, vol control funds continue to draw focus in severe selloffs
One year ago today, on August 24, 2015, severe volatility drove S&P 500 futures to be halted in pre-market trading, listed SPX option markets to go black, and other equity market dislocations to arise. That moment was one of the most severe shifts in SPX volatility, switching from a relatively low volatility period to extremely high volatility (11% selloff in a week) almost instantaneously. Vol control funds, multi-asset investment portfolios with a dynamic asset allocation determined by market volatility, were important contributors to the severity of that selloff. In this piece, we provide background on vol control funds and guidance on how investors can monitor them going forward.
Vol up, sell stocks: a market feedback loop
Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop. Product growth has slowed - but rebalancing impact has grown in illiquid, risk-averse markets. This has been, and continues to be a driver, of the repeated pattern of sharp selloffs followed by consistent rebounds seen in the last 2Y, and contributes to high skew and vol-of-vol in derivative markets. Several fund features - most importantly lags in trading following a volatility spike - keep the products from becoming a systemic risk. Vol control products are not the only large market feedback loop structure (risk parity, leveraged/inverse ETPs, and CPPI are other important ones) - but we believe they are the most important feedback loop given their size and responsiveness to market shifts.
Sharp transitions from low vol to high vol are becoming increasingly common
The most important trading implication of a large vol control market is the funds' impact on sharp selloffs. We have had almost as many transitions from very low vol to much higher vol in the last 6Y as we have had in the prior two decades.
DB Vol Control Composite tracks current positioning
Through fund-by-fund research of $200bln of vol control funds, we have categorized the funds into four categories, and created a DB Vol Control Composite model based on systematic strategies that we believe captures the essence of these products' equity allocation patterns. We estimate that a sudden 4% global equity selloff today would drive $20bln of selling by vol control funds - less than earlier this year - as realized vol is now below many funds' thresholds.
Last August, around $50bln of equities were sold by vol control funds
We estimate that in the aftermath of the Aug-15 selloff, vol control funds sold around $50bln of global equities, and in the aftermath of the Brexit vote sold around $25bln. These numbers are large in absolute terms - and stand out when they're coming from an investment type that does minimal asset allocation rebalancing on a typical day-to-day basis.
Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead thanks to central banks meddling. A clear illustration of the impact of "Brexit" was discussed in our conversation "Optimism bias" back in June, which clearly caught "off-guard" many pundits. This "Brexit" sucker punch or Blue Monday" price action was clearly illustrated in Deutsche Bank 's very interesting report:
"Brexit: what matters is how big a surprise the vote was
In the aftermath of the UK's referendum to exit the EU, vol control funds likely sold around $25bln of global equities due to the sudden pickup in volatility. This would have been different had polls been more accurate: had market-implied Brexit likelihood drifted toward a Leave result over several days rather than shocking market participants in the middle of the night, markets may have ended at the same prices - but in a gradual path. Unlike what actually happened, this slow-motion drift toward Brexit would have left vol control products fully invested. It's not the outcome of the Brexit vote that drove selling by these investors - it's the path markets took to get there.
In the figure below, we compare the number of SPX shares held by a $10bln investment in a hypothetical fund linked to the S&P 500 Managed Risk Index - Moderate (a representative index of some vol control funds that we describe later in the note) under two scenarios: what actually happened, and a hypothetical slow-motion Brexit in which the market hypothetically realizes that Leave will win over the course of the vote week. The shock nature of the Brexit vote caused 900,000 shares of the SPX to be sold by this strategy than it would have had just four trading days' prices been replaced with a gradual descent toward the post- Brexit low.
Vol control products aim to achieve a fixed realized vol
Volatility control products are funds that promise their investors a specific realized volatility – either by aiming to achieve an exact number (e.g. 10% realized vol), a specific range (e.g 8-12% realized vol), or a limit (no more than 12% realized vol). The volatility objective is a constraint on the otherwise return-maximizing goal of the portfolio.
We define vol control funds as products having these characteristics:
■ Dynamic asset allocation. The percentage of assets invested in equites varies, at least partially systematically, over time based on market conditions.
■ Asset allocation is a function of volatility levels. The product's allocation to equities is primarily a function of how high either equity volatility or cross-asset volatility is, whether measured through implied, realized, or subjective metrics. We do not include products whose asset allocation is a function of asset classes' relative volatility to each other.
Typical vol control funds are global, multi-asset portfolios
Even though vol control funds are largely a US-based investment option, most vol control funds are managed as global asset allocation portfolios, including equities and fixed income, from both US and international markets. They typically hold almost-static allocations to either security-level or fund-level investments, and then manage the overall expected volatility of the portfolio by trading futures
contracts on global equity indices in response to changes in market volatility. The charts below show the asset allocation of the long and short sides of a typical vol control fund. The fund holds a diversified, multi-asset long portfolio, and then reduces its equity exposure by 17% of AUM via several short futures positions:
In similar fashion to CPPI strategies, these funds must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds".
As we have pointed out, positive cross-asset correlations are on the rise and should be monitored and of great concern. As we pointed out in our short August conversation "Positive correlations and large Standard Deviation moves", indicates growing systemic risk we think. As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...That simple.
The below chart made on Bloomberg by Adnan Chian (through our twitter feed), represents an illustration of the risk for "balanced funds" getting "unbalanced" as mentioned above:
In addition to this, we read with interest Bloomberg's take on rising correlations from their article from the 31st of August entitled "Stocks and Treasuries haven't moved together like this since China's Yuan devaluation":
"The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."
In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.
"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.
The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party." - source Bloomberg
"The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge." - source Bloomberg
"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.
According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."
Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.
However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013We could not agree more with our friends. In addition to this, dear member of "The Society of the Friends of Truth", is that when it comes to Risk Parity and "Risk" we reminded ourselves Bank of America Merrill Lynch US Equity Derivatives Research note from the 30th of August 2015 entitled "Risk parity is not the risk, vol control is, but how big is it really?":
"Risk parity is not the risk, vol control is
Much has been made recently of the threat of forced selling by risk parity funds during market shocks as volatility spikes. However, the risk in our view lies not in the basic construct of a risk parity fund, but rather in the risk-management mechanism often overlaid onto risk parity funds (as well as other funds) which aims to manage an investment such that it has constant volatility. This “target volatility” risk overlay is a dynamic portfolio rebalancing mechanism that can induce rapid shifts in a portfolio’s allocation, particularly when volatility spikes from a low base level, which is when these funds apply maximum leverage.
The perverse side effects of vol of vol tail events
Our core thesis for volatility in 2015 was that we would witness a greater number of “local tail events” or contained but violent shocks in markets including volatility due to bank deleveraging, waning liquidity and the growth in high frequency trading. The recent market events appear to be yet another example of these risks playing out. A byproduct of these violent shocks, which erupt from a calm, low vol market, is true tail events in the volatility of volatility – the VIX recorded its largest 2-day percentage rise in history last week. This is also a toxic mix for strategies that aim for constant volatility exposure as the amount of leverage they employ is directly linked to their volatility.
Vol control applied to risk parity can further exacerbate risks
Because risk parity funds are inherently low volatility strategies (the recent volatility of an unlevered fund is less than 5%), they are often levered to achieve higher volatility (and higher returns), and in many cases a volatility control is also overlaid to maintain a more constant risk exposure through time. Risk parity derives its low volatility from the diversification benefits of holding both stocks and bonds in equal risk weighting. However, if a spike in volatility occurs at the same time that bond/equity correlation breaks down, this will lead to even larger spikes in risk parity volatility and therefore greater de-leveraging. In theory if these funds were large enough, their rapid liquidation of both bonds and stocks could lead to heightened correlation thus further exacerbating their rise in volatility and demanding further deleveraging.
From theory to reality, near term risks are much reduced
Volatility control is a dynamic risk-management strategy that has been applied widely inBy now you probably understand our "nervousness" in these strategies given that if correlations break down, and they are by the way, then no doubt that there is a heightened risk of "fast and furious" deleveraging at play.
recent years, not only to risk parity funds. If we assume $400bn in risk parity funds, half of which use vol control, we estimate recent events could have generated $30-$80bn in selling pressure on equities and $50-150bn on bonds. Estimated selling pressure from risk-control funds applied to non-risk parity portfolios could equate to an additional $25bn- $50bn in equity selling, which together is less than 10% of the $1.7tn of S&P 500 e-mini futures traded last week. Interestingly, we also see almost no evidence of impact on the Treasury futures market despite estimated liquidity demands from risk parity rebalancing being even greater. This selling pressure also assumes funds all operate mechanically. Many funds can exercise discretion to smooth out their rebalancing. Importantly, for those funds that operate mechanically, they likely have already de-levered, and with volatility now elevated, further shocks will be much less impactful." - source Bank of America Merrill Lynch.
All these strategies suffer from not only "optimism bias" but from a "herd mentality", meaning everyone is playing the same way, this for us reinforce somewhat this "doom-loop" or negative feedback loop which would entail much steeper drawdowns for these strategies than anticipated. All in all, these strategies we discussed are very sensitive to a spike in volatility, and what matters therefore as shown by the "Brexit" episode is not the news outcome but the "velocity" of the news to have an impact on the forced deleveraging prospects for these investment strategies mentioned. After all asset allocation strategies allocate capital on the basis of volatility. When "The Cult of the Supreme Beings" aka central bankers mess with the signal (VIX index), we wonder how "Vol control" is going to operate if indeed we get very large volatility moves going forward as put it bluntly by Bank of America Merrill Lynch in their 2015 report:
"It is really the combination of a sudden, violent drawdown following an extended period of calm that is most toxic for target volatility funds and generates the largest potential rebalancing needs" - source Bank of America Merrill LynchSo what to do in this kind of "environment", we think that "diversification" is being threatened by rising positive correlations, therefore, increasing cash levels, cash being a strategy is therefore paramount in the case of violent intraday drawdowns and sudden spike in volatility.
When it comes to Fixed Income, what would really drive a sell-off in the asset class, would be a return of inflationary pressures. When it comes to our views, us being members of the Society of the Friends of Truth, we are in the "lower for longer" camp and until we see a clear manifestation of wages pressure in the US we will sit tightly in the deflationary camp. This brings us to our second point about "inflation" and "flows".
- Macro and Credit - Is inflation back into play?
"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015Obviously has indicated by Markit, our case for UK linkers in August clearly blew away our preference given the performance of UK linkers over US linkers with a very significant performance overall:
But, given our "deflationary" incline and the embedded deflation floor of US linkers, from a diversification perspective we continue to like the asset class, particularly given as of late of the significant inflows through ETF as indicated by Société Générale in their ETF Market Signals note from the 5th of September entitled "Record creations on inflation-linked bonds":
"Inflation-linked bonds came back to net creations after net outflows in July and posted all-time-high $600m monthly inflows, mainly thanks to USD denominated benchmarks (see chart 6).
Now, as per our October 2015 conversation, inflation-linkers, even in a rising cross-asset correlation world bring diversification benefits, although they have not been immune to the rising trend in cross-asset correlations. However their embedded deflationary floors at least for US linkers make them, we think particularly attractive. What is of interest is that unlike US TIPS, Gilt linkers do not benefit from this "deflation" floor. In a growing NIRP world with now some European Investment Grade companies (Henkel, Sanofi), US linkers have the advantage that both the principal face value and the coupon payment can never decline below the value at issuance. How that for a financially repressed world we dare to ask dear members of the Society of the Friends of Truth?
If we are indeed, in a prolonged period of deflation, such as the one we think we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets. This is particularly true for believers like us that, the US economy is weaker than what every pundits think and that, going forward, US growth is likely to disappoint (see recent PMI for services for example...).
As we asked ourselves back in October 2015, could the the Fed really hike when US breakevens are falling , which could be clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing:
"Gridlock = Goldilocks
Our analysis suggests the market is pricing an easy victory for Hillary Clinton but a split Congress in the November elections. In other words, the market is pricing a high probability of continued gridlock in Washington. We believe this is the reason why the market is long risk parity trades and short volatility right now.
Risk-off ahead of November 8
Risk parity portfolios have not done well when uncertainty and volatility go up. History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections. We recommend buying a 3-month AUD/USD digital put to position for a possible unwinding of risk parity trades that can become self-fulfilling once it starts.
Clean sweep = higher USD and higher US rates
We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook." source Bank of America Merrill LynchFrom our perspective, as members of The Society of the Friends of Truth and given our long lasting contrarian stance, we would tend to fade the "easy victory" for Hillary Clinton and as, we posited in our first bullet point, we would rather go short risk parity trades and long volatility right now, no offense to Bank of America Merrill Lynch. We do not want to suffer from "Optimism bias" but we are not yet falling for the "pessimism bias", we tend to sit nicely in the "realistic bias" camp. Overall, the big issue for risk parity trades comes when both volatility and correlation of the underlying components rise together. This we think is going forward a very important factor to keep in mind. Furthermore, we think that option markets are too complacent and pricing too little of a potential move. With risk parity still remaining levered at elevated levels, this we think could turn out to be a "bad recipe" for asset prices and significantly "boost" the "velocity" in the surge of "volatility".
When it comes to our inflation expectations, we continue to believe that wages acceleration hold the key to the "recovery story", so far, we are not buying it, and we will continue to fade it hence our attraction for the embedded deflation floor of US linkers.
For our final chart, we would like to point out to our fellow members of the Society of the Friends of Truth, that the unintended consequences of the "The Cult of the Supreme Beings" aka central bankers has had an impact on hedging budgets (particularly because both duration risk and credit risk have risen).
- Final chart: The downward trend in bond yields has limited insurers' hedging budgets
"Low interest rates, high vol-of-vol, and volatility aversion have driven growth
Three financial market trends have been catalysts for growth of vol control
■ High vol-of-vol. Volatility itself has been volatile for the past few years, and as a result insurers' hedging costs have been changing quickly. In this environment, vol control funds' more stable volatility profile is particularly valuable to issuers.Furthermore, there is a well a clear warning in Deutsche Bank's note for the pundits such as pension funds that keeps picking up pennies in front of a steamroller namely selling volatility:
■ Low interest rates. Interest on invested funds can be another source of hedging funds for insurers. With US interest rates repeatedly hitting new lows, insurance companies have little margin for error. Stabilizing hedging costs is one way to reduce the need for this cushion.
■ Post-financial crisis worries. Investors continue to be haunted by the ghost of 2008: recency bias has driven heightened worry about another 2008-like event. This volatility aversion has made volatility control attractive to investors (as a peace-of-mind feature) - even in products that do not have the technical hedging needs that drive much of the growth." - source Deutsche Bank
"Tail protection for short vol strategies increasingly timely at low vol levels
The growth of vol control products has, at least at the margins, the potential to re-frame how volatility sellers manage their positions. Conventional wisdom has typically been that selling vol is more dangerous at very high vol levels than it is at low levels despite the seemingly more attractive entry points. However, the potential for market feedback loops like vol control funds to intensify selloffs that start at low vol levels makes short vol strategies riskier at low starting vol levels - increasing the need for tail protection as an overlay." - source Deutsche BankAs a member of the Society of the Friends of Truth, we could not agree more. Any good trader will tell you that being short gamma is a very poor risk/return proposal....particularly pension funds with fiduciary duties we think...
"In a time of universal deceit - telling the truth is a revolutionary act." - George OrwellStay tuned!