When last we checked in on JPMorgan’s Marko Kolanovic, the Street’s most recognizable name was weighing in on the complete “collapse” of confidence that played out during the worst December for US equities since the Great Depression, but also on the necessity of understanding the nuance of the systematic flows discussion.
That latter point is even more critical now than it was prior to Q4. The investing public’s understanding of how systematic flows impact the market is not growing commensurate with that same investing public’s awareness of that impact. That sets up a scenario where words like “robots”, “algos”, “Terminators” and “Skynet” are bandied about with reckless abandon, with no regard for nuance.
To be sure, we’re guilty of that latter tendency, but only because we try to inject some humor and also because sometimes you have to choose a catch-all given that writing 15-word titles isn’t the best way to endear readers to important posts and articles.
We spent quite a bit of time explaining the context for Marko’s last note and we think we did a fairly admirable job of providing a comprehensive, value-added assessment for readers.
Part and parcel of that discussion is the idea that systematic flows have the potential to exacerbate volatility and sap liquidity, a situation which can then snowball on itself in a self-feeding loop.
Well, Kolanovic is out with a sweeping new piece on Wednesday that finds him endeavoring to answer what he describes as “several” client inquiries about the mechanics of that self-feeding dynamic. Suffice to say his exposition is well worth the read and we wanted to highlight some selected passages and visuals here.
First, Marko establishes the link between volatility and liquidity, where the latter is simply market depth which, as regular readers are acutely aware, has gotten considerably worse over time (i.e., it’s diminished).
Describing the chart on the left in the set of visuals shown below, Kolanovic notes that the relationship “is very strong and nonlinear e.g., market depth declines exponentially with the VIX.” That, Marko underscores, is the crux of the matter. “Given that an increase in volatility often results in systematic selling, this relationship is the key to understand market fragility and tail events”, he writes.
In the right pane above, you can see that negative relationship between volatility and market depth (i.e., liquidity) has become more pronounced (i.e., gotten “worse”) over the past decade.
The real kicker here is when Marko notes that when volatility spikes, the VIX becomes the only thing that matters when it comes to liquidity. To wit:
Figure 3 shows the % of liquidity variation that can be explained with the VIX over time (rolling R-squared). The higher the VIX, the more liquidity is driven by the VIX, and recently up to ~80% of liquidity variations were explained by the VIX.
It all falls neatly into place from there and again, regular readers can probably write the rest of this script themselves.
“An increase in volatility typically leads to an increase in systematic selling, which happens in an environment of reduced liquidity, and hence can produce outsized market impact”, Kolanovic continues. That becomes self-referential. Volatility spikes lead to less liquidity and also to systematic de-leveraging, which means selling into a falling and illiquid market, which in turn drives volatility higher, and around and around.
Marko goes on to document the influence of option hedging activity, noting (consistent with his previous work) that index option hedging flows can have a big impact near the close when vol. spikes. And while he reminds you that “the largest of all systematic flows by size and impact” is indeed index options hedging, “the increase of trend-following and volatility targeting components cannot be ignored.”
Critically, Marko explains, in just a few sentences, why all of these strategies end up exacerbating price action. To wit:
Trend following and volatility targeting strategies are also typically short gamma. Volatility targeting can be applied to any portfolio (e.g., 60/40, risk parity, factor portfolio, a platform of fundamental PMs, etc.). Volatility targeting is explicitly short gamma in a mean-reverting market. The strategy reduces risk when volatility is rising and increases risk when volatility is falling. This is by design (risk exposure ~1/volatility), and in that way flows from these strategies are closely related to option hedging. Note that we estimate the notional amount of these strategies at ~$300bn in mutli-asset portfolios, which is much smaller than the delta weighted put open interest in Q4 of ~$750bn notional just for the S&P 500 index. In addition, these strategies sell over several days (unlike option hedges that sell within a day). CTAs’ short gamma exposure is not explicit, but still intuitive as they sell when an asset price declines, and buy when it goes up (additionally, many CTA strategies volatility target).
Kolanovic is careful to add the obligatory “I’m not trying to call anyone out here, but…” disclaimer. He of course doesn’t phrase it that way – i.e., that’s not an actual quote from the note – but increasingly, sellside analysts are careful to note that they are not trying to be pejorative, but rather, are just stating facts. Here’s Marko:
The analysis above by no means passes judgment on the merits of various short gamma systematic strategies that are often used for hedging or risk control.
Right. And see, he shouldn’t have to say that. Nobody should be mad at strategists who endeavor to document the evolution of modern market structure and explain how that evolution is affecting liquidity provision.
Clearly, systematic investors aren’t the only ones who sell into vol. spikes and who get caught up the melee when things are falling apart, and nobody ever suggested that they were. Carbon-based traders/investors play a role too.
All caveats aside, the above just is what it is. These flows make a difference, and when you throw in the liquidity-volatility nexus, you end up with a feedback loop that has the potential to play havoc across markets.