Remember when just a few months ago, every dip in the stock market was met with a strong bid.
Now, it seems, every rally is met with strong selling.
There are several reasons for this shift, which is entirely rational. Most important is a sharp rise in volatility, which has forced risk managers to derisk.
Last year, rolling 30-day volatility in the Standard & Poor’s 500 averaged an extremely low 6% annualized, according to Bloomberg data. In the first three months of this year, by contrast, the realized volatility of the S&P 500 has more than tripled, averaging about 19%. You don’t need to be a “quant” to know that when volatility in the equity market triples, money managers typically reduce their allocation to risk assets to stay within their mandated risk limits and parameters. Unless an investor manages money without any concern for risk, such an increase in market volatility will most likely creep into asset-allocation decisions.
Let’s put a little bit more flesh on these bones. Suppose we have a simple portfolio with 60% in equities and 40% in bonds. Further, let’s assume that the equity exposure is in the S&P 500, and the bond exposure is in the Barclays Aggregate index. In 2017, 30-day volatility of the equity market was about 6.3% (with a high of about 9.5% and a low of about 3.5%). Bond-market volatility was about 2.4%, and the correlation between stocks and bonds was about minus 28%. Putting these numbers into the formula that converts the volatilities and correlations of individual assets into total portfolio volatility, we find that the volatility of this 60/40 portfolio was a remarkably low 4.75%.
Fast-forward to 2018, however, and the picture is dramatically different. Equity volatility has soared to 19%, as noted, bond volatility has stayed relatively constant at about 2.5%, and the stock/bond correlation has been minus 15%. Feed these numbers into the formula, and the result is volatility of about 12.3% for this same 60/40 portfolio.
Let’s say you had wanted to increase the portfolio’s volatility in 2017. (Assume for this discussion that taking more risk leads to more potential return, as the capital-asset pricing model suggests). In that case, you would have had no choice but to increase your exposure to equities. To obtain 10% volatility for the portfolio, assuming fixed bond exposure of 40%, would have required a whopping 145% exposure to equities. In other words, you would have to lever the equity exposure.
You could do that by trading futures, or maybe by buying stocks and exchange-traded funds on margin, or by selling volatility via levered securities, such as inverse-volatility exchange-traded notes – vehicles that imploded spectacularly in February. Indeed, investors did all of the above, as margin debt, futures open interest, and volatility selling all increased to records in 2017.
You also could have levered by investing in mutual funds that lever equity-market exposure (something done in spades by investors hungry for returns). Corporations don’t target volatility, but issued bonds to buy back stock, which is another way to lever the market. Regardless of how it was done, levering risk assets was the only way to increase the volatility of the portfolio when the volatility of the individual assets was low.
Now assume you held this 145% equities/40% bond portfolio coming into 2018. Suddenly, as equity volatility tripled, plugging in the numbers would reveal total portfolio volatility of 28.5%. That’s a big number, and well above the goal of running a portfolio with only 10% volatility. To return to a lower risk target, you would have to derisk the levered equity exposure. With the stock/bond correlation falling somewhat, and your bond allocation holding fast at 40%, you would have to sell more than 90% of your equity exposure to bring the total equity exposure down to about 50% of the portfolio.
The exact numbers aren’t that important here. What is important is that a recalibration of volatility forces significant derisking and deleveraging. Note that I am not even speaking about risk parity or other “sophisticated” strategies, although they aren’t that different from what I have described. The simple fact is that as long as markets remain volatile, there will be selling by rational investors to bring the total portfolio volatility back in line with their targets. If they can sell on upticks, so much the better, since that can likely monetize embedded gains.
Is the current environment of relatively higher volatility here to stay? Note that a 19% volatility reading isn’t really that high; it only looks so in the context of the past few years. The real anomaly was the incredibly low realized and implied volatility we saw in 2017. A volatility reading of 19% is right around the midrange over 100 years of stock-market volatility. The fear is that the regime shift from 6% to 19% volatility hasn’t completely found its way into asset allocation – and asset prices.
Recalibration takes time: Asset allocations are sticky, and investors like to continue doing what they have been doing recently, especially if it has been profitable. But if risk management is important for long-term survival, then recalibration to the new volatility regime eventually will have to happen. That means equity-market rallies from here will be met with derisking, which for now means taking profits off the table.
Any views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the views of LongTail Alpha, LLC, its affiliates or other associated persons thereof. This article was originally published on Barrons.com on March 30, 2018.