There is evidence that the financial system has adapted to low fixed income yields through an expansion of explicit and implicit short volatility strategies. These strategies earn steady premia but bear large volatility, “gamma” and correlation risks and include popular devices such as leveraged risk parity and share buybacks. The total size of explicit and implicit short-volatility strategies may have reached USD2000 billion and probably created two dangerous feedback loops. The first is a positive reinforcement between interest rates and volatility that will overshadow central banks’ attempts to normalize policy rates. The second is a positive reinforcement between measured volatility and the effective scale of short-volatility positions that has increased the risk of escalatory market volatility spirals.

Cole, Christopher (2017), “Volatility and the Alchemy of Risk”, October 2017.

The post ties in with SRSV’s lecture on non-conventional monetary policies, particularly the side-effect of market addiction to low volatility, and the lecture on price distortions, particularly the section on feedback loops.
The below are excerpts from the paper. Emphasis and cursive text have been added.

The danger

“A dangerous feedback loop now exists between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on that volatility. In this self-reflexive loop volatility can reinforce itself both lower and higher… The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility.”

On the link between rising monetary policy rates and broader market volatility view post here.

“The role of active investors is to find value, but when all asset classes are overvalued, the only way to survive is by using financial engineering to short volatility in some form… In world of ultra-low interest rates shorting volatility has become an alternative to fixed income… The global demand for yield is now unmatched in human history. None of this makes sense outside a framework of financial repression.”

On the nature of financial repression view summary here.
On the risks and side effects of non-conventional monetary policy view summary here.

“Modern portfolio theory conceives volatility as an external measurement of the intrinsic risk of an asset. This highly flawed concept, widely taught in MBA and financial engineering programs, perceives volatility as an exogenous measurement of risk, ignoring its role as both a source of excess returns, and a direct influencer on risk itself…Systematic strategies are based on market volatility as a key decision metric for leverage… The majority of active management strategies rely on some form of volatility for excess returns and to make leverage decisions. When volatility is no longer a measurement of risk, but rather the key input for risk taking, we enter a self-reflexive feedback loop…Volatility is now an input for risk taking and the source of excess returns in the absence of value. Lower volatility is feeding into even lower volatility.”

On the difference between volatility and risk view post here.

The short-volatility trade

Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield. Most people think volatility is just about options, however many investment strategies create the profile of a short option via financial engineering. A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all of these risks even if they are not explicitly shorting options.”

“A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability.”

“Short volatility can be executed explicitly with options, or implicitly via financial engineering. To understand this concept, it is helpful to decompose the key risks. The investor holding a portfolio of hedged short options receives an upfront premium, or yield, in exchange for a non-linear risk profile to four key exposures [1] rising Volatility; [2] gamma or jump risk; [3] rising interest rates; [4] unstable cross-asset correlations. Many institutional strategies derive excess returns by implicitly shorting those exact same risk factors.”

“Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability… The active investor that does his or her job by hedging risks underperforms the market. Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle’… a structure dangerously exposed to fragility.”

The size

“The global short volatility trade now represents an estimated over $2 trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. We broadly define the short-volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk taking. Many popular institutional investment strategies, even if they are not explicitly shorting derivatives, generate excess returns from the same implicit risk factors as a portfolio of short optionality…

  • Explicit short volatility contains upward of only $60 billion in assets, including $45 billion in short volatility pension put and call writing strategies, $8 billion in short volatility overwriting funds, $2 billion in short volatility exchange traded products, and another $3 billion in speculative VIX shorts. Explicit short volatility strategies are active in the short term, fading short and intermediate volatility spikes. Volatility spikes that mean revert quickly help the performance of these strategies. Explicit short volatility is most harmed by an extended period of high volatility that fails to mean revert, such as in 1928 or 2008, or a super-normal volatility spikes such as the Black Monday 1987 crash.
  • Implicit short volatility are strategies that, although not directly selling options, use financial engineering to generate excess returns by exposure to the same risk factors as a short option portfolio. Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure, including between $400 billion in volatility control funds, $400 to $600 billion in risk parity, $70-175 billion from long equity trend following strategies, and $250 billion in risk premia strategies. These strategies are similar to a short option position because they…are subject to non-linear losses based on variance, gamma, rates, or correlation change. The strategies tend to have longer time horizons for rebalancing than explicit short volatility. In practice, exposure to equities is reduced based on the accumulation of variance over one to three months.”

The share buybacks issue

“Since 2009, US companies have spent a record $3.8 trillion on share buy-backs financed by historic levels of debt issuance. Share buybacks are a form of financial alchemy that uses balance sheet leverage to reduce liquidity generating the illusion of growth… [More than] 40% of the earning-per-share growth and [over] 30% of the stock market gains since 2009 are from share buy-backs.”

Share buybacks are a major contributor to the low volatility regime because a large price insensitive buyer is always ready to purchase the market on weakness…The market cannot rely on share buybacks indefinitely…Rising corporate debt levels and higher interest rates are a catalyst for slowing down the $500-800 billion in annual share buybacks artificially supporting markets and suppressing volatility

The risks

Gamma risk: “Imagine you are balancing a tall ruler vertically on your palm. As the ruler tilts in any one direction, you must to overcompensate in the same direction to keep to the ruler balanced. This is conceptually very similar to a trader hedging an option with high gamma risk. The trader must incrementally sell (or buy) more of the underlying at a non-linear pace to re-hedge price fluctuationsWhen large numbers of market participants are short gamma, implicitly or explicitly, the effect can reinforce price direction into periods of high turbulence. Risk parity, volatility targeting funds, and long equity trend following funds are all forced to de-leverage non-linearly into periods of rising volatility, hence they have synthetic gamma risk.”

Correlation risk: “The concept of diversification is the foundation of modern portfolio theory… The financial engineer…reduces the risk of a portfolio by combining anti-correlated assets… All modern portfolio theory does is transfer price risk into hidden short correlation risk… Many popular institutional investment strategies derive excess returns via implicit leveraged short correlation trades with hidden fragility… Correlation risk can be isolated and actively traded via options as source of excess returns. Volatility traders on a dispersion desk will explicitly short correlations by selling the variance of an index and going long the weighted variance of its constituents. When correlations are stable or decreasing, the strategy is very effective, but when correlations behave erratically large losses will occur.”

Interest rate risk: “Risk parity is a popular institutional investment strategy with close to half a trillion dollars in exposure. The strategy allocates risk and leverage based on variance assuming stable correlations… The risk parity strategy, decomposed, is actually a portfolio of leveraged short correlation trades (alpha) layered on top of linear price exposure to the underlying assets (beta). The most important correlation relationship is between stocks and bonds. A levered short correlation trade between stocks and bonds has performed exceptionally well over the last two decades including in the last financial crisis… The truth about the historical relationship between stocks and bonds over 100+ years is illuminating… Between 1883 and 2015 stocks and bonds spent more time moving in tandem (30% of the time) than they spent moving opposite one another (11% of the time)…It is only during the last two decades of falling rates, accommodative monetary policy, and globalization that we have seen an extraordinary period of anti-correlation emerge.”

On the nature and risk of leveraged risk parity strategies view post here.

The end game

“Volatility fires almost always begin in the debt markets…Volatility regime shifts are driven by the credit cycle. Volatility is derived from an option on shareholder equity, but equity itself can be thought of as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.