In June 2007, two relatively obscure Bear Stearns mortgage funds closed. With the benefit of hindsight, this was the start of a wave of mortgage defaults that heralded the start of the financial crisis.
In October 1987, a stock market correction turned into a rout as a trading strategy called portfolio insurance saw markets accelerate lower - falling over 20% in the US and 40% in Australia.
Are the ructions in the volatility market the pebbles that are going to start the next avalanche?
The Bear Stearns case is not the right analogy in my view. What we saw in 2007 were serious economic issues (overpriced houses and an over-indebted consumer, extended by financial engineering without the capacity to pay) beginning to emerge. The economic trend was already in place, the factors were affecting the real economy and the economic boom had run out of steam. The failing mortgage funds were merely reflecting the economic reality.
The 1987 crash is more similar, but there are also a large number of differences.
1987 was largely attributed to portfolio insurance trading strategies, where selling triggered stocks to reach levels that then triggered more selling and so forth downward.
In essence, there do seem to be similarities, the difference is largely in financial conditions are quite different, both interest rates and inflation were rising but several percent in 1987, the economy was slowing. In 2018, economies are still growing, interest rates and inflation have edged up and are still very low. More importantly, the size of explicit short vol strategies is nothing like the size of portfolio insurance, and the addition of circuit-breakers to markets helps to limit the downside.
But the market does have vulnerabilities to a broader range of implicit short volatility strategies. Just not yet. I'll detail this more below.
Lost in the excitement of 2007, in August a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Basically, many of them were using the same strategies and it seems like large selling by one fund triggered falls which led to selling by other funds with then spiralled downward.
About a quarter of the large quant funds eventually closed as 2/3rds of the money invested left the sector - asset consultants and investors were shaken pulled much of their remaining investments.
In my view, the current slide is more similar to this. A short price correction becomes steeper due to losses in a particular strategy that became popular and the unwind sends stocks even lower.
The net effect is devasting for the investment managers who run the strategies, but not the rest of the market.
Its a moderately complicated trade that has been around for a long time, but was popularised by some listed exchange-traded notes that opened the trade up more broadly.
A bit like Inception this trade lies several layers away from the real world:
The interesting factor is that if you are long volatility it is like buying out of the money call options - you are making bets on long-shots. And long shots don't come in much and so you generally lose money. Until one day when you make a lot of money.
Short volatility is the opposite. Every day you make a little bit of money before one day when you lose a lot.
Short volatility has been a great trade for years. But this week has been the time when they lose a lot.
The unwinding of a short volatility position usually creates selling pressure with makes markets more volatile which then triggers more short volatility positions to unwind and so on.
Many (myself included) suspect that this is what turned what may have been a "garden variety" stock market decline into to rout on this week, and may trigger further falls.
There is (was?) not that much money in explicit short volatility trades. Probably less than $100 billion.
The bigger threat is whether it spreads to other strategies which are running a very similar strategy like risk parity or var control. There are a few trillion dollars invested in these strategies, and this would threaten markets enough to have a 1987 style crash.
What would it take to shake out these similar strategies? Rising interest rates and a sudden sell down could spark the unwind. The issue is that interest rates rising from 2.7% to 3.0% is not enough - it would probably need to be at least a few percent. The sudden sell down would probably also need to be large, 10%+ maybe. As each strategy is subtly different it is hard to tell.
Much like an avalanche, the conditions need to be present (too much snow) and then the conditions need a trigger.
In my view, the conditions are not there to trigger an avalanche without some sort of external shock (some sort of geopolitical strife probably, or maybe stock markets crashing for a different reason). And if we have a few months breathing space, the current "mini avalanche" might serve to reduce the probability of a big avalanche later - I'm pretty sure most of the Short Vol investors that just lost all their investment won't be rushing to invest again in the same strategy. And maybe some of the investors in similar strategies will re-assess their risk.
There is a market vulnerability in that there are a lot of investors chasing strategies that are similar to short vol, strategies that force markets lower when they unwind, which then trigger more selling which sends markets even lower.
However, I don't believe the conditions are there for this vulnerability to turn into a major issue without a major external shock.
Damien Klassen is Head of Investments at Nucleus Wealth.
The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.