Look, I realize that pounding the table on forced unwinds by vol.-sensitive investors during the recent acute pickup in volatility is quickly becoming an exercise in dead horse beating.
Or, if you like cows better than horses, we’re quickly reaching the point where the sellside is going full-Bruce Dickinson when it comes to penning notes about what last week meant for portfolio managers operating near their risk limits ahead of the turmoil – “analysts have a fever, and the only prescription is more vol. notes.”
Be that as it may, there is exactly zero chance that people are going to stop trying to project what the scope of the de-risking was likely to have been for various types of investors. This is where we get to quote a classic passage from a 2017 Heisenberg post. To wit:
Beating dead horses has become a hobby of ours.
Although “posthumous equine abuse” isn’t something we’d list under “interests” if we were say, signing up for a dating site, we don’t mind engaging in it if we think doing so might drive home a particularly important point.
The only caveat here is that I’m not entirely sure this point is in fact “important” -especially to the extent it’s already happened and might have run its course (much more on CTAs and risk parity here).
But do you know what I am sure of? I’m sure you’re still interested in “more cowbell” and more dead horse beating when it comes to de-risking tied to the volatility spike and “guess what?” I’ve got the “prescription.”
Barclays is out with something a little more general that just looks at what the implications were for global portfolio managers with positions already close to pre-defined risk limits who “may have had to reduce these over the past week, particularly if these limits were measured with a Value at Risk (VaR) metric using forward-looking implied volatility.”
I don’t know how laborious this exercise was for Barclays and relatedly, I’m not entirely sure it was worth the effort, but ultimately, they created three global portfolios as follows:
- an unhedged equity portfolio using MSCI All Country World Index weights;
- an unhedged bond portfolio using Bloomberg Barclays Global Aggregate Bond Index weights; and
- an FX overlay assuming a USD-based investor with 60%/40% equities/ bonds portfolio weighting
Next, they used 3-mo. implied vol. measures for the assets in each one, assumed a mean return on par with the last six-ish years, and calculated the distribution of returns before and after the recent bout of market turmoil.
Obviously, they’re trying to guesstimate (or “infer” in you want to make it sound more precise) what the forced position reduction in each of those portfolios might have been assuming the manager was running maximum risk headed in. Here are the results:
If you’re having trouble understanding that, here’s Barclays to explain by way of the equities example:
For example, assume a risk manager is comfortable with an equity portfolio manager losing USD1mn in one month 5% of the time. Prior to the recent pickup in volatility, Figure 1 shows the 5th percentile equity portfolio return was -21.1%, suggesting a maximum position size of approximately USD4.7mn to stay within the defined VaR limit of USD1mn. With the recent pickup in implied volatility, however, the 5th percentile move has become more negative as the distribution of returns has become wider and is now -29.5%, implying a new VaR of almost USD1.4mn for the same portfolio – well above the USD1mn risk limit. To return to the VaR limit, the portfolio manager needs to reduce the position by about 28% to approximately USD3.4mn.
There’s a ton more in there about what this likely meant for different currencies (this is from the bank’s FX team), but the bottom line is pretty simple. “The VaR analysis, although highly stylized, illustrates that the extreme moves in equities globally, and the accompanying increase in implied volatility, might have forced portfolio managers to reduce risk indiscriminately across assets, so as to keep within overall portfolio risk limits,” the bank writes.
Again, the key word there is “indiscriminate” and as Barclyas also warns, any further sign from the inflation data this week that price pressures are still mounting risks catalyzing still more volatility.
There you go. More cowbell.