The steady grind higher in equities and well-anchored volatility has translated into elevated exposure for systematic strats, although just how elevated depends on which strats you’re talking about, and who you ask.
One thing we can all agree on, though, is that exposure is running high for the vol-targeting crowd. This is common sense, and it has echoes of January 2018.
“Given the decline in volatility, volatility targeters are fairly long equities, with exposure in the ~80th percentile”, JPMorgan’s Marko Kolanovic wrote Wednesday. Morgan Stanley concurs. Vol-targeting leverage is now in the 81st percentile since 2011, the bank says.
The visual is a proxy for vol-control exposure. What you’ll note is that it’s characterized by a demonstrable “escalator up/elevator down” tendency. In the simplest possible terms, some worry that with exposure now running near the highest levels since just prior to the February 2018 VIX ETN “extinction event”, the market could be set up for a nauseating ride down the elevator.
This is, to a certain extent anyway, another manifestation of the tail wagging the dog. “Volatility is the trigger”, Nomura’s Charlie McElligott remarked, in an expansive November interview. “Volatility is the toggle by which positions are grown or reduced”.
Speaking in generalities, vol-control funds trim their overall leverage to maintain a fixed portfolio volatility. When stocks fall, projected volatility tends to rise, so these funds sell risky assets. That, in turn, can exacerbate selloffs.
That selling can then ripple out, triggering more mechanical selling. “CTAs are important because what they are is picking up a very unemotional reversal of a trend”, McElligott said, in the same November interview linked above.
Estimates differ on the exposure of other key systematic investor cohorts. Kolanovic pegs CTA exposure in the ~65th historical percentile, for instance, while Morgan’s QDS team puts it in the 78th percentile.
There are a couple of crucial points to keep in mind in this discussion.
First, there will never be another February 2018. The trigger for what market participants not-so-affectionately refer to as “Vol-pocalypse” was the realization of the rebalance risk inherent in the levered and inverse VIX products. They no longer exist – or at least not in the same way they did then. “Unless a bomb goes off in the middle of downtown Manhattan in the middle of a trading day, we will never see that amount of short vol need to be rebalanced at the end of the day”, McElligott reminds you.
As for the vol-targeting crowd, remember that they aren’t going to just de-risk en masse, all at once, in one afternoon. The scary-looking plunges shown both in the first chart above and in Morgan’s illustration belie the fact that, as Deutsche Bank reminds you, “they would need to see a large and sustained spike in vol for their selling thresholds to be hit”.
JPMorgan’s Kolanovic implores you to internalize that. “Please note that, on average, volatility targeters don’t follow short term equity volatility, but rather medium-term multi-asset volatility”, he said Wednesday.