AUGUST 25, 2017 VIEWS ON VOLATILITY

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1 AUGUST 25, 217 By most standard metrics, financial market volatility is at or near all-time lows. This is not only true for realized volatility, but also the market s expectations of future volatility. This seems highly counterintuitive. As we have detailed many times in the past, there is no shortage of potential risks in the world today, and we can now add nuclear war with North Korea to the ever-growing list. While we have been warning our clients about the myriad of risks facing the global economy and capital markets for years now, we are hardly alone in that regard. Many of the risks facing the world today are not only very real, but also quite obvious and seemingly well-understood. Yet, month after month, quarter after quarter, financial markets seem to be in a world of their own. Why is this? How much longer can this persist? What happens if and when markets finally begin to price in some of these risks? Perhaps most importantly, how can investors protect themselves today with an eye towards opportunistically adding to risk assets at cheaper levels in the future? We have been pondering these questions for quite some time and present some of our latest thoughts here. Historical Perspective The most commonly used metric to gauge investors expectations of future stock market volatility is the Chicago Board Options Exchange Volatility Index, better known as the. 1 As shown in the chart below, the is currently near all-time lows, and has been for quite some time The level of the VIX index is based on the implied volatility of near-term options contracts on the S&P 5. In other words, it is meant to reflect the market s expectations of near-term future stock market volatility. While the VIX index itself is not an investable security, there are futures and options contracts directly tied to the index and, in recent years, a number of ETF and exchange-traded products referencing the index as well. MEKETA FIDUCIARY MANAGEMENT, LLC A SUBSIDIAR Y OF MEKET A INVESTMENT GROUP, INC 5796 ARMADA DRIVE SUITE 11 CARLSBAD CA fax

2 While the captures most of the headlines, volatility and volatility expectations have not only collapsed in stocks, but in other asset classes as well. The chart below shows indices that measure the same concept of implied volatility in interest rates (i.e., bonds) and foreign exchange markets. Interest Rate and Foreign Exchange Implied Volatility Merrill Lynch Option Volatility Estimate (MOVE) Index JP Morgan Global FX Volatility Index MOVE Index FX Volatility Index 5 5 Why is Volatility So Low? There are a number of potential explanations for this low volatility phenomenon. The first is a topic that we have discussed many times in the past, central bank policy. Since the Global Financial Crisis, central banks around the world have implemented unprecedented amounts of monetary stimulus, in part to drive a recovery in financial markets. While initially positioned as short-term emergency measures, nine years removed from the crisis the aggregate global central bank stimulus is currently greater than ever. Billions of USD $2, $18, $16, $14, $12, $1, $8, $6, $4, $2, Central Bank Balance Sheets FED ECB BOJ BOE SNB PBOC % of GDP $ Data is as of June 3, % of GDP

3 Not only have central banks increased their levels of stimulus over time, but they have been extremely quick to react to any signs of financial market weakness with promises to do even more. This has helped result in a market dynamic that is often referred to as the central bank put. In other words, a situation where market participants believe that central banks are committed to doing everything in their power to actively engineer positive market outcomes and nothing else matters. While it is true that the Fed has finally begun to raise interest rates and has openly discussed shrinking its $4.5 trillion balance sheet, per usual they have gone to great pains to communicate their plans far in advance so as to avoid catching markets by surprise (and sparking volatility). This communications strategy was largely developed by Alan Greenspan during his tenure as Fed Chair, and has been carried forward by his successors. The most recent example was the Fed s rate hike cycle in the mid-2s, a period that spans both the Greenspan and Bernanke eras. The Fed raised interest rates from 1% to 5.25% over a period of roughly two years, significantly tightening monetary conditions, yet market volatility remained extremely subdued throughout as each incremental 25 basis point hike was telegraphed far in advance removing all suspense. Of course, we all know how that story eventually ended. 6 Fed Funds Target Rate (Upper Bound) Fed Funds Rate (%) 1 1 We may be witnessing something similar today. Even though the Fed is raising rates and forecasting a shrinking of their balance sheet, markets seemingly believe that (a) the removal of stimulus will be extremely deliberate so as not to disrupt financial markets, (b) any changes in the Fed s plans will be telegraphed well in advance, giving investors plenty of time to adjust, and (c) if market conditions do actually deteriorate in spite of all this, the Fed will quickly reverse course and inject more stimulus. Another reason why market volatility has been so low has been the growing popularity of investment strategies that are either explicitly or implicitly short volatility. In response to the zero and negative interest rate policies of central banks in recent years, investors who are desperate for yield have been chasing it in increasingly dangerous ways. Many of these strategies involve enhancing returns at the margin by writing (selling) options or using other derivatives-based strategies that are quite profitable so long as volatility remains at subdued levels. In other words, it 3

4 is more or less a bet that market volatility will remain at or below the level implied by the price of the option before it expires. These types of strategies can make sense when implied volatility is relatively high. Given that we are now at all-time lows, we can only surmise that the continued popularity of these strategies is based solely on the fact that they have worked so well in recent years. As volatility grinds lower and lower, shorting it becomes less and less profitable, while the risk of a reversal only grows larger. Shorting volatility at these levels strikes us as a classic pennies in front of a steamroller type of trade. Like any investment strategy, however, widespread popularity can be a self-fulfilling prophecy. As falling volatility has encouraged more and more investors to bet on a continuation of that trend, the growing amount of money that is shorting volatility itself serves to push down volatility even further. Why is Low Volatility a Problem? Low market volatility is not necessarily a bad thing. There have certainly been historical periods where low market volatility was completely justified. But today does not strike us as one of those times. The first risk of low volatility is that it implies a degree of complacency in financial markets that may be inconsistent with what is happening in the real world. There are far more metrics to measure financial market volatility than real world volatility (e.g., politics, social issues), but one such metric is the Economic Policy Uncertainty (EPU) Index 2 as shown below. While the EPU Index and the tracked each other quite well for the better part of 15 years, recently there has been a notable disconnect. 2 The EPU Index uses three underlying components. One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty. More details can be found at 4

5 Bloomberg has developed another way to estimate the degree of market complacency with what they call their Complacency Index. This is simply the ratio of global stock market valuations (EV/EBITDA of the MSCI World Index) to the. This index recently hit an all-time high, passing the previous record levels reached in Bloomberg Complacency Index 1. Complacency Index Similar to the earlier reference of short volatility strategies, the risks created by persistently low volatility have been exacerbated by the widespread popularity of investment products or investment approaches that mechanically increase leverage as volatility declines. Strategies that target a certain level of realized volatility (e.g., 15%), for example, need to continually ramp up their leverage as expected volatility falls in order to reach their targets. Risk Parity strategies represent a similar dynamic. Risk Parity strategies seek to create an equal risk-weighted exposure to both stocks and bonds, and therefore need to lever up more stable bond portfolios to make their expected risk commensurate to that of equities. 3 As volatility drifts ever lower, the quantitative models that often drive these strategies extrapolate the recent past into the future and call for more leverage. There are many more examples of strategies like these, but they all have one thing in common: volatility goes down, leverage and risk exposure goes up. This creates a potentially dangerous situation if volatility ever does return to financial markets in any sustained way. In that event, the self-fulfilling dynamic of falling volatility increasing the performance and popularity of leveraged short volatility strategies, which then pushes volatility down even further, potentially begins to work in reverse. Rising volatility may force these strategies to unwind leverage, which would only push volatility higher (and markets lower), leading to more deleveraging, and on and on in a vicious circle. In this way, even a temporary spike in volatility could spark a market correction, rather than the other way around. 3 This is an overly simplified example of a Risk Parity strategy with only two asset classes (stocks and bonds). In reality, most Risk Parity funds will invest in a much broader range of asset classes in the hopes of superior diversification. To the extent that these additional asset classes are riskier or less liquid than investment grade bonds, however, adding leverage to the equation makes the portfolio even more dangerous in the event of a spike in volatility. 5

6 What Could Cause a Spike in Volatility? Any number of actions could cause a spike in realized and implied volatility levels. Geopolitical risk has certainly been heightened in recent years with growing populist and nationalist sentiment all over the world. This has only ratcheted higher in recent weeks with the escalating North Korea situation and other lesser known conflicts such as that between China and India. As already mentioned, after nine years of ever-increasing monetary stimulus, global central banks are finally starting to inch towards the exits. Removing trillions of dollars of stimulus was always going to be a far greater challenge than initiating it, and there is certainly a material risk that things do not proceed according to plan. Furthermore, what if markets react negatively to the removal of monetary stimulus, which causes central banks to reverse course and start the Quantitative Easing process all over again, but this time it doesn t work? Will markets begin to lose faith in the omnipotence of central bankers? Will the central bank put discussed earlier finally be called into question? These are just a handful of the potential risks that we can identify and, to some extent, prepare for. The most risky events, of course, are the ones that we don t even know about - the true Black Swans. While trying to predict the future is always a dubious exercise, with financial markets at record levels of complacency, any shock at all could have an outsized negative impact. What Should Investors Do? In our view, the end goal is straightforward implement exposures today that will not only help our client portfolios mitigate a future rise in volatility, but also provide the dry powder necessary to opportunistically increase exposure to risk assets at more attractive valuations. For institutional investors with a required or targeted annual return, this is trickier than it sounds due to timing and implementation. While volatility rising and markets falling is a real risk, so is the opportunity cost of missing out on a few more quarters or even years of this bull market. Further complicating matters is the fact that there are far more investment options that benefit from falling volatility than benefit from rising volatility. Most traditional investment options are inherently short volatility, whether that is the explicit intention or not. Thus, even if one wants to play the other side of the volatility trade, there is a relative lack of options with which to effectively do so. Meketa Fiduciary Management has sought to balance these competing risks in a number of different ways on behalf of our clients. The most straightforward is to maintain a modest allocation to high quality bonds and cash. While holding these low-yielding instruments in a perpetually rising market is painful, it is also prudent. These safe and liquid investments not only provide a buffer against future volatility, but also represent dry powder that can potentially be deployed back into risk assets at more attractive valuation levels. Gold and gold mining equities are another potential hedge against a rise in market volatility, particularly if it is caused by a geopolitical event or a loss of confidence in central banks. Finally, a word on the role of hedge funds. As you know, we tend to be quite skeptical of hedge funds in general (too expensive, too opaque, too illiquid, redundant risk exposure, etc.) But there are some very notable exceptions, and many of those exceptions happen to fall into the general category of long volatility (i.e., funds that can benefit from a rise in market volatility) 4. 4 There are a number of ways in which hedge funds can effectively create long volatility exposure. Examples include buying long-dated, out-of-the-money put options that should increase in value as markets fall and/or implied volatility increases. Another example is certain trend-following strategies that have the ability to quickly reverse market exposure from net long to net short as markets correct. 6

7 As mentioned earlier, long volatility exposure is much harder to achieve via traditional investments than short volatility exposure. In other words, while we believe the same risk exposures that many hedge funds provide can be more cheaply and safely expressed through traditional investments, long volatility is an exception. In addition, we believe the role of long volatility hedge funds is potentially enhanced by the current bond market/interest rate environment. During most historical market corrections, investors have been able to offset some of their equity market losses with gains in their investment grade bond allocations to help mute the impact on their overall portfolio. But what if this time is different? With global interest rates already near all-time lows (i.e., bond prices already near all-time highs), how much more can bonds rally in an equity bear market? Furthermore, what if rising interest rates (i.e., falling bond prices) are actually the cause of the next equity market correction? In our view, adding non-traditional equity market hedges, such as gold and long volatility hedge funds, helps to protect against the risk that bonds do not play their traditional diversifying role in the next market downturn. 7