After building out Merrill’s mortgage trading floor basically from scratch, then moving to the buyside at Pimco, several weeks ago Harley Bassman, more familiar to many traders as the “Convexity Maven” – a legend in the realm of derivatives (he helped design the MOVE Index, better known as the VIX for government bonds) – decided to retire (roughly one year after his shocking suggestion that the Fed should devalue the dollar by buying gold).
But that did not mean he would stop writing, and just a few days after exiting the front door at 650 Newport Center Drive in Newport Beach for the last time, Bassman wrote his first full article as a “free man”, in which the topic was, not surprisingly, derivatives and specifically the recent collapse in vol – and convexity – what prompted it, but most importantly and what everyone wants to know: what threshold would be sufficient to finally launch the next “critical mass” market move (i.e. crash) and, just as importantly, what could catalyze it.
He answer all of the above in his latest fascinating note.
Bassman’s full thoughts below:
“Rambling near the Edge”
Last month I attended the EQD (Equity Derivatives) Conference in Las Vegas. Diverse speakers opined upon a variety of topics, but a common theme was noting the near record low of both Implied and Realized Volatility in the financial markets. But despite the VIX kissing its nadir, realized volatility has plumbed even lower depths, and thus it was reported that strategies that engaged in selling Equity Volatility had both superior returns as well as the loftiest Information (Sharpe) Ratios among the dozens of strategies offered.
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There are many vanilla investment constructions that decline to use derivatives, yet are actually negatively convex portfolios in sheep’s clothing. These include:
- Low Volatility – An equity portfolio devised by purchasing the least volatile stocks. Over the past few years these portfolios have generally out-performed the generic Index;
- Equity Volatility Targeting – Embedded in many equity-linked insurance products, these risk targeted (often called “Managed Risk”) portfolios increase/decrease investment leverage on a formula based upon realized volatility;
- Risk Parity – Similar to Equity Volatility targeting, but here the investment universe is widened to include fixed-income, currencies and commodities.
What all of these investment themes have in common is that not only do they profit when realized Volatility is low, but also that their implementation tends to make disadvantageous transactions (selling low and buying high) when Volatility increases; in other words, these strategies are implicitly short Convexity.
Every generation of investor builds a framework to support their portfolio construction, and I would propose that our current proclivity for “quant supported” notions has led to an over reliance upon Information Ratios (IR) in portfolio construction. So, while I do believe IR is a useful investment tool, I also believe it has quirks that can be underappreciated. Thus, my main complaint is that IR managed portfolios tend to increase leverage; and usually at the wrong times.
In simple terms, would you prefer to buy an asset (strategy) with a 15% return and a 30% Vol (IR = 0.5), or a 5.1% return asset with a 3.4% Vol (IR = 1.5)? Seemingly the latter is better, especially if we lever it 3x to a 15.3% return (with a lower volatility). But this is somewhat similar to selling a deep OTM put; usually a winner, until it isn’t.
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So, the ultimate, and frankly the only, question one cares about is identifying the tripwire that would tip our system into disequilibrium and force a self-sustaining reduction in risk (leverage/convexity).
And this is where the conference paid for itself. While most speakers declined to answer, one panel proposed that many of these passive portfolios can be synthetically constructed as long an Index plus short a +/- 4% out-of-the-money strangle. Thus, it seems possible that as little as a 4% decline in a single day could be enough to create critical mass; and this does not seem terribly inconsistent with many current risk parameters.
A decade ago institutional investors supported only 20% of Hedge Fund assets; presently, these investors (with a concomitant demand of narrower risk limits) make up 80% of the asset class. Since it is common for as little as a 6% drawdown to ignite a “stop out” procedure at many Liquid Alternative portfolios, it does not seem unfounded to think that risk reduction measures may preemptively commence near this 4% inflection (strike) point.
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So, the follow up question on your tongues might necessarily be: “What could be the catalyst to trigger such a significant pull back?”
For the record, in a rare burst of modesty, I will say I do not know; that said, I think that Inspector Clouseau will find higher interest rates lurking near the scene of the crime. Moreover, I expect two sets of fingerprints will be found: 1) The FED, and 2) OMB/Treasury. As offered by many analysts, corporate stock buy backs have been an overwhelming support for equity prices. And as shown below, one wonders if the nearly 20% pull-back in 2011 was staunched only by the relentless – blue line – bid from Corporations.
In fact, away from Corporations purchasing equities (buy-backs or mergers), it is unclear who else is supporting the stock market against the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into –blue line- bonds. [You think ObamaCare is divisive, just wait until they “means test” Social Security.]
I can offer no proof, but common sense seems to support the notion that the cost of money (interest rates) should have some bearing on how much money one cares to buy (borrow). So clearly higher rates driven by the FED could reduce buybacks funded by debt. But an additional twist is that the real cost of debt must include tax benefits, and consequently, if tax reform were to include a provision to reduce the tax advantage of corporate borrowing, that would raise the effective cost of debt, and may be the catalyst for reducing share buy-backs.
While President Trump, with some support from Congress, has promised significant policy alternatives with respect to Healthcare, Immigration, Budgeting, and Trade, if asked to point to THE EVENT that will precede a significant bout of noxious volatility, I propose that it will be an unintended consequence of Tax Policy; and specifically, as noted above, related to the effective cost of debt.
Full article: Derivatives Trading Legend: “As Little As A 4% Decline In One Day Could Start A Critical Crash” (ZeroHedge)
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