SYZ Alternative Summit Geneva

When more than USD 1 trillion was wiped from the value of US equities in just one day in early February, the comeback of volatility became one of the hot topics of 2018. Some USD 3.2 billion in short volatility positioning was wiped out ultimately leading to USD 2.6 trillion of S&P 500 losses. Yet Paul Britton, manager of one of the largest volatility funds, still believes it is a strategy worth considering. In fact, Britton is on a mission to bust the myths of volatility. “Most view volatility as a defensive strategy, but it is not just about protection, it is about diversification,” he said, with a chart illustrating the five types of volatility. “What happened on the 5th of February was a reckless risk-taker not pricing risk appropriately,” Britton argued.

A bigger concern to Britton is that banks are now out of the risk-taking business and are no longer providing the liquidity to smooth out market events. With USD 1.86 billion of value-at-risk in Q4 2008, banks were once the largest balance sheets in capital market history. At the end of 2017, however, bank VAR stood at just USD 377 million and it is this absence of bank balance sheet that is impacting market reactions to recent events, explained Britton. Risks of a liquidity mis-match is therefore much more present because the banks’ balance sheets have shrunk. That said, Britton firmly believes that February’s event, like 2008, is a one-off tail event. During his 20 years’ experience in the volatility markets, Britton has seen 62 closes of the VIX index below 10 and 52 of them occurred in 2014. He does think, however, that there could be a new volatility regime on the horizon closer to the long-term median of 14.7% realised. The median VIX (implied volatility) is currently around 17% and this seems to him like a fair long-term implied volatility level.

Britton said that because 2017 volatility levels were driven by short volatility funds, the 2017 data should be taken out of any statistical models, as he is convinced that these levels will not happen again. His rationale is based on the changes to tax reporting on corporate buybacks, which have been a tailwind to equities and a dampener of volatility, as well as the likelihood of the Federal Reserve raising interest rates. Britton cautioned that while strategies, such as VIX, volatility exchange traded notes and ETFs, which make up the intrinsic volatility market do not move the markets per se, the biggest risk is a market structure event. He explained that the level of volatility influences the size of the leverage in the markets and that strategies such as risk parity and volatility targeting CTAS, which make up the extrinsic markets, also use the level of volatility to determine their trading activity and exposure levels. More simply, lower volatility leads to higher allocations to CTAs, more leverage and ultimately more exposure to the equity markets through the risk parity funds as the intrinsic and extrinsic markets are tethered to each other.

The extrinsic market strategies have more than USD 1 trillion in assets, so when volatility strikes, these strategies can move the markets and which were behind the damage to the equity markets earlier in the year. For this reason, Britton asked whether in the future the volatility levels, as measured by the VIX, could indicate the direction and level of the equity markets; suggesting the growing importance of measuring and monitoring the volatility levels.

• Volatility is not just a defensive strategy, but an asset class that can add diversification
• Banks are no longer liquidity providers making space for new entrants
• Increased likelihood of new volatility regime closer to the long-term median of 14.7%.

In today’s low yield environment, the diversified portfolio requires a performance enhancing alternative to bonds. In his presentation full of comparative graphs and charts, Guido Bolliger, co-head of Quantitative Solutions, demystified alternative risk premia by explaining their return stream had contributed to part of some hedge funds’ performance for decades. He highlighted that unlike traditional hedge funds, premia are a more liquid, more transparent and less expensive way to get portfolio insurance.

Defining the four main types of risk premia as value, trend, carry and defensive, Bolliger explained value and trend premia are based on investor behaviour. Echoing Paul Britton’s comments on the lack of liquidity providers in the market today, he explained that carry risk premia is compensation for providing liquidity to the market and taking on ‘crash’ risk.     

While the history of risk premia dates back a long time, a lot of the products are new. Bolliger cautioned investors to be wary of back tested data in the risk premia space, suggesting they look at the live data, despite it only having a short track record dating back to 2012 to 2014. For risk premia, investors need to avoid over-fitting and cases where the back tests look great by the live performance is disappointing. Looking at a chart of historical correlations between risk premia from June 2014 – March 2018, Bolliger highlighted the low correlation with bonds and equities. He went on to explain the role of portfolio construction by showing four ways to allocate to premia: equally-weighted; inverse volatility: risk parity; and tail risk based.

Bolliger pointed out that each of the four ways had their pros and cons. For example, an inverse volatility portfolio suffers less during a market draw-down, while risk parity portfolios got hit in February 2008, when volatility spiked. Because risk premia enhance both risk and return, Bolliger explained how to blend different premia as part of the portfolio construction process. He emphasised that with average returns of 4% to 5%, risk premia were not a hedge fund alternative, but a bond replacement.

• Value Premia: buying cheap assets is rewarding but not an arbitrage
• Trend Premia: the trend is my friend but less so since 2014
• Carry Premia: equity-like returns but not without risk
• Defensive Premia: long safe assets/short risk ones (suffers during market rebounds)

Global macro manager with a long-term horizon, Al Breach painted a relatively positive big picture of the economy. Almost. Despite hedging his statements with the caveat that cycles can end mid cycle, Breach foresees a ‘likely’ boom in the economy and that trade, politics and oil aside, it was hard to be worried. Reminding the audience of the old adage “cycles do not die of old age”, Breach’s optimism is founded on the basis that he believes that we are not in the later stage of an economic cycle, but mid cycle. There is room for the economy to grow both further and for longer and so theoretically this is the time to invest in ‘risky’ assets.

Breach’s evidence for being in the middle of cycle includes the fact that the huge output gap has closed; there is no over-utilisation of factories; and we are not yet into the capital expenditure boom phase. Additionally, there is no significant leverage in the system, which is typically the case in late-cycle phase. Financial balances are also sound, Breach explained pointing to a Goldman Sachs recession risk indicator heat map chart. This showed the private sector as benign with banks strongest on record (largely due to the increased regulation).

Other charts in Breach’s presentation showed that growth is upbeat, now led by capital expenditure, and that unemployment, wages and inflation are all low too. With the prospect of quantitative easing ending; wages and inflation picking up where unemployment is low; and production output is strong, Breach’s main negative outlook is that he finds most assets relatively expensive. In particular bond prices. The fact that quantitative easing is decreasing, combined with the USD 1 trillion US budget deficit forecast for 2019 and the strong possibility the Federal Reserve will hike rates—which Breach predicts it could go as high as 4%—leads him to believe headwinds are brewing in the bond markets.

The 35-year bond bull market is over, Breach said, pointing out that the vast majority of investors still own long bond portfolios at a time when an increasing number of instruments such as ETFs and passive products offer daily liquidity. He points out that a recession can hit even mid-cycle, perhaps provoked by external shockssuch as geo-political factors, and as such Breach foresees a long queue at the door if investors ever decide to get out of their products in a rush.

Overall Breach is bearish on the US curve and pointed to the current US administration needing a boom to get re-elected and worried about a potential Thucydides Trap with immigration and trade in addition to war as the three pillars on which to run a campaign.

• Currently mid-way through an economic cycle, not late stage as some suggest
• Real risk that the Federal Reserve could hike rates to 4%
• Bond market rout a possibility

After four or five years of deflation, China, which is still an industrial economy, is now benefiting from the visible hand of government intervention, said Daniel Poon. The Greater China expert and founder of Zeal explained that the Supply-Side Reforms, which have been in place since 2016, are driving reflation as the government seeks to balance the supply and demand of products, so the prices can go up.

In 2017, based on valuations and earnings, China was one of the top performing markets up 54.3% according to the MSCI China Index, yet growth seems stagnant at 6% to 7%. Poon believes that when it comes to China, people focus on the wrong metrics. “The market mis-place their concerns on real growth, when nominal growth matters a lot more”. Environmental problems are taken seriously in China. As part of its bid to reinvent itself, China is actively focusing on the environment with its Environmental Protection Reforms. New laws are being passed regularly, making corporations cautious with their capital expenditure because they do not know what the new laws will look like. For this reason, there is less risk of overcapacity in the country.  

Additionally, the Supply-Side Reforms have not only seen production cut but this has had a knock-on effect of decreasing air pollution, said Poon. Air pollution remains a key social and economic issue for China, so much so that the Ministry of Environmental Protection now monitors air pollution real time and poor performance on environmental factors is the death sentence of a political career, Poon noted.

Overall, China has had the best earnings upgrade of 8.3% amongst major countries in Asia Pacific including Japan and the emerging markets. The high China consumer confidence index is explained in part by the good economic results, but also now by the trust that employees have in the political regime. This in turn means that current and future reforms are likely to receive the support of the people. Looking forward, Poon said that China is becoming a front runner in research and development, innovation and new technology. He referred to a collection of charts that showed year on year, China has aggressively moved to narrow the IT gap with the US and separately it has outpaced US, Korea, Japan and German with respect to robot sales and its share of global high value-added exports, compared to these four markets.

• Focus on nominal growth not real growth numbers
• Reflating the economy with Supply-Side Reforms
• Aim to become a front runner in technology