Volatility and Tail Risk Investing

Managers and investors consider a new environment for risk

Originally published in the April | May 2016 issue

The debate over volatility as an asset class has become much noisier of late, in large part because financial markets have entered new territory, but also because volatility trading or investing has started to enter mainstream territory. There are far more investors active in the market than there were 10 years ago, and a wide diversity of players that has been creating more inefficiencies. Part of its popularity has been the arrival of the post-2008 low growth environment, coupled with the opportunity to hedge tail risk with volatility-based products.

A new economic conundrum has also got investors concerned. Today, as Paul Donovan, global economist with UBS Investment Bank, recently pointed out at the annual London Volatility and Tail Risk Hedging Educational Event, it is less a question of the collapse of trade globalisation, and more a case of the collapse of capital flows (now at 6% of global GDP versus 20% in 2008). This is being partly driven by the regulation that effectively forces banks to bring capital closer to home, for example through the implementation of more aggressive capital controls. Donovan noted that the capital flows that have been most affected are those into debt and equity markets, creating a drain on market liquidity. “As local markets are being regulated more aggressively, creating  captive investment pools, market rates of return have collapsed,” he says

The situation is being exacerbated by the buy and hold mentality of many investors, particularly in the wealth management sector: their appetite for corporate bonds, prompted by the quest for income, is further reducing liquidity, along with a variety of other factors.

We are left with a situation where financial markets are becoming divorced from economic reality – market data is now less reflective of overall economic health. It is bank lending and inter-company credit that is now more reflective of the economy, Main Street rather than Wall Street. The difference between real and nominal data is becoming increasingly important in any analysis of future investment returns.

On top of this data is becoming increasingly unreliable – investors and hedge funds are taking initial numbers issued by governments at face value, and not waiting for the inevitable revisions. Discrepancies arise as a consequence. This is leading to a ‘deflation mentality’ in the US, for example.

Response rates on the surveys used to compile that data have also descended, to now nearly 50%. Economists are turning instead to tax return data, such is the discrepancy between official data and reality. “Central banks are looking at a different world from financial markets,” says Donovan. “This is going to have to change over time. Economies and markets are not communicating.”

The managers’ view on volatility
Where does this leave hedge funds, who might traditionally have hung on every word from a central banker’s lips? For starters, it means volatility swings are back with a vengeance – financial markets have become structurally much more fragile. With this has come a desire by both managers and investors to manage volatility as an asset class in its own right. Investor appetite is demonstrated by the amount of retail investor interest in structured products based on the VIX index, for example from Asian investors.

Managers who trade volatility are very sanguine about what can go wrong. Regulators are focusing on ensuring that major crashes of the flavour of October 1987 are not repeated. Banks are no longer being incentivised to trade and warehouse risk. But it is volatility of volatility which provides the most accurate measure of the extreme risk that the market can face, August 2015 being a case in point.

“[In August] the VIX was not calculated for 15 minutes – we saw 1200 stops in the US equity market, and not just on the downside,” says Pierre De Saab, a partner with Dominice & Co. “A lot of the ETF providers had problems calculating their prices. This is a good flavour of how things can go badly wrong, and we could see this in the next crisis.”

In effect risk itself needs to be parcelled out more efficiently – investors could, for example, be more incentivised for holding risk. Under the current situation banks are pushing out random risk because regulation has not been adaptive to actual risk. It is obvious to managers like De Saab that there has been a shift to market participants with tighter time horizons and shallower pockets than was the case back in 2006-07 when investment bank prop desks were bigger participants in the market.

Many investors were stung in August when the VIX rose from 14 to 55; a large slice of the sellers of volatility have not returned to the market in the wake of that shock. With so few sellers, it was obvious that cost of carry had become huge when the January sell-off occurred.

“Investors are becoming dissatisfied with long VIX positions,” comments Jacob Weinig, founding partner and portfolio manager with Malachite Capital.

In August, despite the rally in spot VIX, VIX futures holders could not make money. Weinig has noted that despite a slower response from systematic volatility sellers re-entering the market, he worries that many retail investors have been short via inverse VIX ETFs, and that an “air pocket” could be created by another rush to cover shorts. “We could have a major event in the volatility markets,” he says.

It took the market six weeks to rebound from January’s problems. De Saab agrees with the prognosis – volatility has become expensive, and, he says, interest in buying volatility is running at an all-time high. “There is a bigger trend at work here, towards a higher level of risk,” he says. “There is a substantial possibility of a major crisis.”

Beyond this is the fact that investment banks have been pulling liquidity out of the market to meet their regulatory obligations, forcing some fund managers to take on a more intermediary role than they perhaps anticipated. Investors as well are finding they are dealing with more OTC counterparties than directly with investment banks, to the extent that clearing houses in some countries – e.g. the Netherlands – are becoming dependent on the flows between investors and other counterparties. This all has consequences for investors.

“A combination of regulations and a lack of investment by the investment banks into their trading desks over the last 10 years is creating opportunities,” says Will Bartlett, CEO of Parallax Volatility Advisers. “We’re seeing the market going more OTC as some trades are becoming too big for the listed market.”

Having said that, he is expecting to see more volatility trading migrating to exchanges as Dodd Frank creates distortions around the swaps market, and thereby creating a situation where risk is diffused across more participants in the market.

There is a fear among some managers that relying on the futures market will prove to be an expensive process. Some argue that OTC transaction costs will decline, just as FX costs have dropped over the past 10 years. More market participants, it is hoped, will create more competition in the OTC space for volatility trades.

No more fuel in the tank?
Managers continue to refer to the fragility of financial markets. Volatility has not been coherent in recent months –it has seen brutal variations for example in out of the money volatility at the end of last year. Part of the distortion is coming from the massive market in volatility-based structured products. There is huge interest, for example, around the potential impact of Brexit on the GBP, FTSE and EuroStoxx.

Following the turbulence of last summer, there has been what Pascal Spielmann, senior investment strategist with LGT Investment Partners, calls “a consensus around consensus.” That, he says has now changed with the episode of August last year, in particular the events of 24 August. There has been an illusion of liquidity in the market, created in part by the order cancelling process adopted by high frequency traders. Typical diversification strategies, for example between equities and bonds, are no longer working as they did. “If decorrelation is breaking down, then we have a problem,” Spielmann observes.

It could also become harder to deliver new growth going forward, particularly if, as projected, the work force does not grow faster than the retired population. In the developed world, this certainly looks like it will be the case. A number of other factors, including wage unit costs, commodity prices and energy costs could also be a drag on returns, potentially working to curtail corporate profits.

“Central banks do not have a lot of fuel left in the tank,” says Spielmann. “QE is not working as efficiently as it did, and pushing rates into negative territory is not working either.”

Regulation is progressively nudging institutional investors towards a more rigid approach to portfolio construction, for example thanks to the Solvency II directive. This is creating a situation where liabilities are high for investors, but asset values are falling. Investors will need to be able to adapt to circumstances.

Spielmann believes investors need to be more nimble and adaptive, balancing their portfolios against a wide range of possible outcomes in terms of market and economic conditions.

Tail risk
Tail risk and hedging against it has become another obsession with investors and managers. In some respects, it resembles efforts to protect assets against the ghost of Christmas future, using knowledge of the ghost of Christmas past. They are both ghosts, but they are very different spectres indeed. A balance needs to be struck between a systematic approach and an active, discretionary strategy. “Every tail is different,” says Richard “Jerry” Haworth, CEO of 36 South Capital Advisors. “You simply don’t know where the uncertainty will come from next.”

It is not just a case of buying volatility and selling delta either – the question is how to combine the different factors within a portfolio. Volatility can be used to provide a strong negative correlation in a situation where everything else is being sold off.

Such complexity is something institutional investors continue to struggle with: savvy managers need to be able to brief investors using scenario analysis, illustrating potential impacts on investors’ balance sheets if tail risk is not managed properly. It boils down to a trade off between different scenarios.

Institutions still want their long-biased equity exposure, but with a tail risk overlay, and managers of so-called ‘black swan’ funds continue to see take up by allocators who are prepared to pay a premium for the additional insurance they can offer.

While structured products are often favoured as tail risk hedging instruments, and seem relatively benign, especially when their long term growth prospects are measured against the cost of a specialist tail risk fund, they have the potential to disappoint when new market volatility scenarios enter the equation.

Many endowments in the US market suffered considerably in 2008-09 as a result of their asset allocation decisions, including with hedge funds. It was a wake up call that has injected an element of caution into asset allocation decisions. Internally, there is plenty of discussion about the relative benefits of tail risk hedging, and whether buying tail risk funds is really worth it. Fees for volatility managers can vary considerably, but as the chief risk officer of one US endowment puts it, “While it hasn’t been really cheap life insurance for us, let’s not get upset that we haven’t died yet.”

Ultimately, it is difficult to measure the value of a tail risk manager in an institutional portfolio: it is striking that many endowments have still not developed a proper tail risk hedging scenario and even insurance companies, who should know better, are behind the curve here. Volatility managers are obviously keen to make their case to investors, but in the absence of a tail risk scenario where they can demonstrate their capabilities, they are being frustrated by a ‘mother knows best’ attitude from many larger investors.

Where is volatility going? In a zero per cent interest rate environment, with insufficient buyers around, it is likely we will continue to see consistent under-pricing in this market. Low volatility and stability is viewed as inherently destabilising by some economists, but volatility spikes are also making for challenging market and investment conditions.

The profoundest worries seem to circulate around the strength of the market infrastructure: volatility players seem confident in their own abilities, but worry about the condition of the pitch they are expected to play on. This is not the pristine turf of yesteryear, they complain, and worry that the match will be called off due to the muddy conditions.

The complexion of the market and macroeconomic environment has changed, but this has served to create new opportunities too, particularly for volatility specialists. After all, it is innovative solutions to these problems that investors are looking for when they turn to hedge funds, rather than a business as usual approach.