A “Useful Maxim” Before “It All Goes Horribly Wrong”

Hedging is so last … ummm… decade?

With central banks backstopping markets and creating a self-fulfilling, vol-crushing, BTFD dynamic, the idea of buying insurance seems not only passé, but outright foolish.

Sell vol with this ETP for a 4,000%+ return over the past 8 years!” “You too can be a carry trader!” “Do NOT sell the populist coup news or risk getting run the fuck over by a vicious VIX smash!” “Oh, and since vol is never going to spike, let that machine over there lever us up some more!”

And on, and on. Recall what Marko Kolanovic said earlier this week (full note here):

Selling of volatility is one of the key parts of risk premia/smart beta programs. Our estimate is that ~20% of risk premia strategies are allocated to selling volatility across asset classes (and about half of volatility selling is via Equity options). Selling of volatility is a yield generating strategy that can be benchmarked against bond yields. Hence declining bond yields invite more option selling activity. Increased supply of options also suppresses market realized volatility through hedging activity. The key risks of option selling programs is market crash risk. If one believes there’s a reduced probability of a market crash, volatility selling strategies look even more attractive. Global central banks have helped in both aspects by lowering yields and reducing crash risks. Indirectly, central banks have managed market volatility over the past decade.

With a near record pace of central bank balance sheet expansion (highest since 2011) and record low levels of market volatility, volatility sellers and other strategies that increase leverage based on market volatility (e.g. Volatility Targeting, etc.) have been further emboldened.

At this junction, the key question is when and how will this end. Will volatility just grind higher as the central banks start normalizing, or will it explode and wipe out some volatility sellers and levered strategies.

Note the two bolded passages. That echoes something Citi said earlier this year while explaining why no one in credit wants to position for spread decompression – to wit:

Against the short-term metrics by which performance tends to be measured, many will struggle to forego the incremental carry – until a negative trigger becomes immediately obvious.

Of course by the time “a negative trigger becomes immediately obvious” it’s too fucking late.

That’s when the tail hedgers win.

So that (and tomorrow’s runoff in France) is the backdrop for the following from Bloomberg’s Cameron Crise who notes that “hedge when you can, not when you need to” is a useful maxim…

Via Bloomberg

Asymmetry is a regular feature of financial markets. It’s well known that asset returns are not normally distributed, and there are an array of market strategies that seek to take advantage of this characteristic. However, not everyone can be on the favorable side of an asymmetric outcome at the same time. It’s a useful discipline for risk takers to periodically review their portfolios; more often than not, the best time to buy insurance is when it feels like you least need it.

  • Almost every investment strategy out there is predicated on some sort of positive asymmetry.
    • Active equity investors believe that they have better information or analysis than the market.
    • Carry traders and vol sellers benefit from strategies that make money much more often than not — and hope that they get out before it all goes horribly wrong.
    • Many macro traders and tail-risk hedgers assemble portfolios that they expect to make much more if they’re right than they lose if they’re not, and hope that they get in just before it all goes horribly wrong for the vol sellers.
  • It feels like for most of my career market participants have characterized the outlook as “unusually uncertain,” and today is no different. To be sure, conviction is high that Emmanuel Macron will win the French presidency and that the Fed will hike rates next month. Yet the political and growth trajectory in the U.S., the state of the financial system in China, and recent weakness in commodities are all issues that could potentially upset the apple cart.
  • It is difficult to make money being a serial buyer of overpriced protection. By the same token, it is also an important risk management discipline to examine one’s portfolio and determine they asymmetric outcomes that could negatively impact it — and mitigate them if possible.
  • “Hedge when you can, not when you need to” is a useful maxim. The art of portfolio management, of course, is to time and size those hedges so that they do not erode the positive returns of the core strategy.
  • Sometimes a hedge becomes so successful that it eventually morphs into a core position. Now that’s the kind of asymmetry that anyone can live with.
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