In discussions with clients, Macro Risk Advisors' CEO Dean Curnutt was reminded of a quote from LTCM partner Victor Haghani. In commenting on the demise of the portfolio, Haghani said,
“the hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.”
Hurricane insurance is not like financial insurance. Pinpointing the “positioning” of equity derivative markets – across listed and OTC options, VIX futures, variance swaps and structured products globally – is elusive. But it is difficult to avoid the conclusion that the success of these trades along with today’s ease of implementation may be leading to over consumption. Coupled with the lack of defensive protection positioned in portfolios, the sponsorship of short volatility trades leaves the market particularly unprepared to absorb the next risk event.
Curnutt's follow-up to this initial insight confirms (from meetings and conversations with clients) that participants' attention has centered on the epic quiet that has overtaken the landscape of cross asset risk.
Volatility readings are low, and so too are correlations both across and within asset classes. Our risk dashboard captures the vast array of options that can be purchased for a song. Discounted prices notwithstanding, there is absolutely no waiting line to buy at the "derivatives dollar store".
With merchandise on the cheap, why would a dollar store fail to attract customers? For one, its consumers might, after spending money over time, realize that the items purchased were not consequential. They were low in cost but not valuable. The option buyer has steadily arrived at the same conclusion, asking him or herself "why insure something that doesn't break?" The US equity market, which barely moves, has forced some pocket book driven soul searching upon even the most risk conscious investor. While markets historically fluctuate considerably when they fall, the two month realized volatility of the SPX on down days only is hovering just north of 5%(!). This dynamic is a powerful disincentive to spend premium even in the face of nominally low hedging costs.
The low level of realized volatility is not just forcing investors out of hedges that have proven costly (and frustrating). Exceedingly muted market fluctuations are encouraging the consumption of trades that capitalize on the flat lined risk profile of developed equity market indices. What does this realized volatility shortfall look like? The current ratio of 3 month SPX implied volatility to trailing 3 month realized has been printing in the 95th to 99th percentile. This wedge between implied and realized has enabled the short equity volatility trade to be among the finest Sharpe ratio trades this year (and last year as well).
There's a second, more subtle but very important risk dynamic at work in the short volatility trade. While flashing a bright "geek alert" warning, we present the concept of “vol of vol" and point to the stability of not just the SPX, but to the VIX itself. More than 100 days have passed since the VIX reached 15. The realized volatility of the VIX is in the 4th percentile of observations over the past 10 years. This low VoV characteristic further empowers the Sharpe ratio of short volatility strategies and coaxes investors to further utilize them. There are two ways to lose by selling volatility – a spike in realized or a spike in implied. Neither has occurred. Without any risk that movement higher in implied can impose a mark to market loss, the short volatility trade has been especially safe.
We argued last week that "Financial Insurance is Not Like Hurricane Insurance.“ Market oriented trading strategies provide feedback to investors that incentivize behavior and potentially lead to crowded trades. While the weather event rests simply in the hands of Mother Nature, the financial market storm may arise itself from the unwind of trades that enjoyed too much success for too long a timeframe. In 2017, the Nomura Equity Volatility Risk Premium Fund (Ticker: NEVRIUS) is an example of such a high success trade. This fund, which systematically sells equity index variance swaps has had quite a run. Since the US election, it has lost money on just 26% of trading days. Importantly, the average loss on such days has been just 17bps. Apparently, shorting convexity through variance is not so scary at all, or so investors are being taught. Far from picking up nickels in front of the veritable steamroller, this trading strategy is hoovering dollar bills from a bingo hall. Profits with impunity are the holy grail.
When market conditions are as stable as they have been, the providers of insurance profit from a risk environment that largely produces benign outcomes. As these profits accrue, they provide positive feedback to the insurance sellers, who compete further and in the process, exert downward pressure on risk premiums. In our most recent piece we said, “The additional pension fund that, on the advice of its consultant, takes on a short volatility “alpha strategy” is adding to the incremental sale of optionality into the marketplace. All else equal, this serves to further depress option prices. It may also mute realized volatility as the collective hedging of long gamma positions creates selling into rising markets and buying into falling ones. A somewhat self reinforcing cycle of low volatility can result: the success of the trade attracts capital that further depresses volatility and leads to more profitability.”
A feedback loop may be in motion in which the success of the trades results in capital allocated to them that in turn makes them more successful. We know that these low volatility periods take longer than we would ever expect to unwind, but it appears that the spring is coiling in the process. Profits are a powerful behavioral incentive.
We finish this thought piece with one of the most ironic set of comments made by a policymaker in history. At the 2005 Jackson Hole confab with the VIX at 13, realized volatility at 8 and the CDX IG at 50, Fed Chair Greenspan said, “Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.” Amen, Alan.
The erudite ex-Fed Chair’s comments are a reminder of the tremendous insights that arise through the George Soros Theory of Reflexivity as it pertains to asset prices. Soros argues that in setting asset prices to reflect the fundamentals, market participants actually have an impact on the fundamentals. Stated differently, financial decisions based on expectations about the future direction of asset prices can affect the very future the decisions anticipate. This circularity creates a reinforcing feedback process that leaves markets open to booms and busts, where asset prices themselves are an important driver of economic outcomes.
Greenspan’s 2005 warning aside, the spring would have more much further coil. According to BIS data, derivatives notional outstanding would double over a two year span beginning in 2006, enabling housing prices to expand rapidly. There are many reasons the current risk environment is safer now than was the pre-crisis period. But as illustrated by Deutsche Bank, asset prices broadly (equities, bonds, real estate) are substantially high, leaving little margin for error. As Vanguard continues to gather inflows at a record pace, a floor is put beneath equities and profits accrue to the insurance sellers. What appears safe, however, may be a function of flows that enable a self reinforcing risk taking cycle even as true market risk is substantially underpriced.
The palpable absence of downside convexity in investor portfolios, along with the increasing implementation of short volatility strategies, leaves the market especially vulnerable to the inevitable shock, especially given lofty asset prices, low rates and thin option prices.
Simply put, financial market insurance is not like hurricane insurance.
Read more here at Macro Risk Advisors…
via http://ift.tt/2oS8dex Tyler Durden