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....MORE