Writing this article amidst COVID, it’s convenient to blame the virus for the everything that’s happening in the markets. While COVID is a significant catalyst, the seeds leading to this market drawdown were cast long before. It is important to recognize the volatility shock precipitated by COVID and the important lessons left behind for the next generation of investors: in particular, around changes to market structure and new paradigms for diversification.
Coming out of the 2008 Great Financial Crisis (GFC), Central Banks were tasked with bringing the global economy back from the brink through unprecedented monetary policy. For a while this worked, but like all market cycles, people eventually adapt to the new rules of the game. Excesses develop and unintended consequences emerged. Leading up to this latest market crash — the fastest decline in history — was a decade long bubble brewing in short volatility (vol) strategies.
Short vol bubbles eventually pop when there are bouts of higher volatility. Like a ticking time bomb, any number of market catalysts would have eventually set off the short vol unwind. In this instance, COVID was the (unfortunate) catalyst that tipped things over the edge.
Looking ahead, there are worrying signs that investors may misdiagnose the reasons for why their portfolio diversification failed during this latest market turmoil. This presents both a risk and an opportunity. This article aims to triangulate key narratives that help to explain the COVID short vol bubble. All in hopes of convincing the next generation of investors to re-think what diversification means, and to prepare for similar situations in the years to come.
CENTRAL BANK POLICY, LOW RATES, AND THE REACH FOR YIELD
In order to stimulate the global economy after the 2008 crisis, Central Banks around the world collectively lowered the global cost of capital by (i) reducing of global short-term rates to zero / negative (ZIRP/NIRP), and (ii) purchasing selected assets from the market to put liquidity (reserves) into the financial system (Quantitative Easing).
The net effect of these actions was a general lowering of returns on all assets classes. This left investors in a tough spot. To hit their modelled / contractual return hurdles (e.g. the magic “7–8%” p.a.), many investors needed to invest in progressively riskier assets in a “reach for yield”. Over time, investors added leverage to their strategies to help make the math work.
FINANCIAL REGULATION SHIFTING OF RISK TO NON-BANKS
In addition to monetary policy, many new regulations were introduced for global banks after the GFC (e.g. Volcker Rule, Dodd-Frank, Basel 3 etc). These regulations were designed to dis-incentivise banks from undertaking risky activities that led to their failure in 2008 by imposing stricter capital and liquidity requirements. As banks arguably became safer in the last decade, their ability & willingness to intermediate risk in the financial markets was proportionally lowered.
Instead, critical risk intermediation functions that were historically undertaken by the banks were passed onto a complex web of lightly regulated non-banks (e.g. Asset Managers, Hedge Funds). These activities include everything from liquidity provision / market making, to collateral-based funding. The key risk intermediation activities that these non-banks undertook post GFC would become central to the bursting of the short vol bubble in 2020.
The combination of central bank policy changes and new regulations, had the net effect of incentivizing many investors to crowd into strategies that were all essentially short volatility and/or dampened volatility. This crowding changed market structure dynamics and created new risks that threatened the validity and efficacy of traditional diversification assumptions.
Some of the key short volatility / volatility dampening strategies that were unwound by the COVID shock:
1) CORPORATE BUYBACK STRATEGIES
The Central Bank imposed low / zero / negative rate environment, combined with reduced bank lending capacity due to new capital & liquidity regulations, led to a boom in corporate debt issuance. As investors were starved for any fixed income investments that returned a non-zero yield, corporates were more than happy to meet the demand.
As investors piled into corporate debt, spreads across the Investment Grade, High Yield and Leveraged Loan universe tightened significantly. Historically risky corporate names were incentivized to borrow money at nearly no cost. Portions of the debt raised was often used to buyback shares.
This created an unexpected market structure dynamic where there was a persistent upward bid for equities (higher demand for equities against lowered supply of shares). This acted as a sizeable volatility dampener (minor equity sell-offs met with corporate buybacks). Buyback flows were so large that estimates placed them as the largest net-buyer of equities in the past decade — a key reason for why equities prices have inflated.
2) YIELD ENHANCEMENT STRATEGIES
In an attempt to squeeze out higher returns in the low rate environment, many investors turned to various “yield enhancement” strategies. These strategies in essence sell derivatives (short volatility) in exchange for income. Functionally this can be conceptualised as selling insurance (collecting a premium).
- In the GFC, a popular type of yield enhancement was the selling of credit default swaps (CDS) on mortgage backed securities (we know how that ended…)
- In the decade post-GFC, the same concept has been replicated, but across all asset classes (e.g. investors all over the world were/are selling insurance on equities, credit, rates, and commodities markets).
To execute these transactions, the derivatives (volatility) was sold through market makers (regulated banks or unregulated hedge funds), who then would (delta) hedge the transactions for risk management and/or regulatory purposes (e.g. Volcker rule).
As yield enhancement strategies grew in size and popularity, not only were investors increasingly short volatility through these products, market makers hedging flows became significant as well.
This created an unexpected market structure dynamic whereby volatility was dampened when investors were net sellers of volatility / financial insurance (client flows were directionally opposite hedging flows). However, when volatility spiked, investors shifted to becoming net buyers of volatility / financial insurance, and hedging flows reinforced volatility (client flows were directionally similar to hedging flows). This is particularly problematic when client flows switch to buying protection (puts) —where hedging flows create downward reinforced selling pressure.
3) SYSTEMATIC / PASSIVE STRATEGIES
In the decade following the GFC, there has been a historic shift from actively managed strategies (humans making investment decisions based on fundamentals), towards passive / systematic strategies (algos / risk models making investment decisions based on programmed rule sets).
Examples of systematic strategies include things like Volatility Targeting, CTAs, Target Date Funds, ETFs etc. The shift in the behaviors of buyers and sellers in the market from humans to machines not only changed the market structure dynamics, but also the paradigm for how prices for securities are set through market transactions.
- When active management strategies are the more dominant flow, security prices are generally set based on fundamental risk analysis — e.g. what a company’s projected future cashflows are likely to be, and therefore if should one buy/sell.
- As systematic & passive strategies increasingly become the more dominant flows (as they have been post GFC), prices are set based on the rule-sets of these systematic & passive players. The implication being that investors need to more carefully consider the positioning of the systematic & passive strategies — e.g. where the algos/rules-based buyers/sellers are positioned in the market, the rule-sets that guide their asset allocation, and triggers where they automatically begin buying/selling.
In the COVID-triggered volatility event, this particular change in market structure resulted in non-intuitive outcomes that both enhanced and dampened volatility in unexpected ways:
- We saw a violent unwinding of institutional systematic sellers when vol levels spiked, liquidity dried up, and rule-sets switched into de-leveraging mode — resulting in a self-reinforcing chain reaction of selling across the market agnostic to fundamentals.
- At the same time, an unchanged apathetic flow of retail systematic buyers remained — indifferently buying their weekly installments of stock and bond ETFs. This unchanged retail systematic buying dampened volatility as they de-facto acted as a buyer of last resort and warehoused the MTM losses of others.
4) RISK PARITY / MULTI-ASSET STRATEGIES
The final piece to the COVID-triggered drawdown is the growing popularity of Risk Parity, or similarly inspired Multi-Asset investment strategies. The most common form of this strategy is the loosely defined “60/40” stock-bond portfolio. These strategies attempt to maximize risk-adjusted returns (defined as returns relative to volatility) by combining different assets (ingredients) into a “diversified” portfolio. The idea being: when one asset falls, another asset rises — thus insulating a portfolio from significant losses / drawdowns.
As market volatility was dampened over a decade, driven by a crowding into short vol strategies, many Risk Parity / Multi Asset investors were implicitly managing themselves to certain market stability assumptions:
- The low vol environment post GFC will exist forever
- Asset class price correlations post GFC will be stable forever
- Leverage, vis-a-vis wholesale funding markets (from banks and non-banks), will always be available
- Government bonds are effective hedge instruments to risk assets (like stocks), and have limited use outside the investment community
All of these assumptions more or less broke down amidst the height of the COVID-triggered volatility: vols spiked (triggering selling), historical correlations broke down / went to 1 (as other short vol strategies were indiscriminately selling ), wholesale markets froze (as dealers risk limits were cut and many funds couldn’t finance positions, resulting in more selling), and popular hedges like gov’t bonds sold off by at the same time stocks did (as gov’t bonds were bought and sold for non-investment purposes — related to central bank QE activity, collateral pledges in repo markets, and mandatory bank liquidity buffers). As all these assumptions were progressively breached, many Risk Parity / Multi Asset strategies need to move to cash as a last resort in order to cut risk exposure.
The short volatility bubble perhaps revealed to many investors the unsettling possibility that their portfolios were not as diversified as they had thought. Or more accurately, that they were diversified…but for world that doesn’t exist anymore.
As the post GFC environment unleashed a new market structure and sticky incentives for investors to crowd into short vol strategies, the conventional forms of diversification, e.g. by asset class / sector / geography, matter less than before. More important is a diversification of the portfolio on the basis of whether strategies are long or short volatility.
If the conditions that enabled a short volatility bubble to grow were activist central banks suppressing asset returns, incentivizing investors to reach for yield, and imposing regulations to force financial intermediaries to reduce risk taking, then it wouldn’t be a stretch to assume that what comes after COVID, is more or less of the same.
Central Banks post GFC said that their unprecedented monetary policy actions were only temporary, and would one day revert. A decade-plus later, these unprecedented policies have become the norm. More worrying, this latest round of Central Bank crisis response has only seen more extreme policies proposed— from the lowering of all remaining global short term rates to zero, talks of yield curve control, QE programs that expand into the purchase of risk assets (corporate credit), to MMT. If anything, incentives to crowd into short vol may get even stronger as the “reach for yield” phenomenon may actually become greater.
Perhaps the greatest danger for the next generation of investors is to falsely attribute this market’s latest drawdown as caused purely by COVID, and not address the root causes.
The reality is this latest market event was catalyzed, not caused, by COVID. What caused it, was the progressively changing market structure post GFC and incentives for investors to shift into increasingly (leveraged) short vol strategies as there was no yield to be found anywhere else.
In this new version of the world, portfolio diversification must evolve beyond conventional dimensions (e.g. asset class, sector, geography), and include new factors in the mix:
- Evolving market positioning & structure
- New / existing regulations that constrain financial intermediaries (altering the flow of liquidity/credit)
- Non-fundamental drivers of securities prices (e.g. systematic / passive players, usage of various securities as collateral for QE programs / wholesale markets / bank buffers etc).
The likely complacency from traditional investors to misinterpret, disregard and/or not incorporate these new factors for diversification into their investment strategies presents an opportunity for those who are informed. This is especially important for the next generation of investors deciding how to save / invest for the decades ahead. Decisions taken today to properly diversify the real risks in this new market paradigm, may reap non-linear benefits as we confront the short vol bubbles that will inevitably inflate again.