Policy Regime Change and Uncertainty

Previous articles have focused on the balance between monetary and fiscal policy, tracing the argument for both a more expansive fiscal stance, and a more radical paradigm shift to fiscal dominance with the emergence of MMT.

The emergence of MMT from the fringes has been positioned as a tool to enable a bigger role for money financing for fiscal ill-discipline, itself a function of resolutely divided politics and the abandonment in the US of fiscal responsibility. 

Despite these issues, monetary policy remains in the driving seat, and the market continues to act on changes in inflation and growth expectations, and eventually a change in anticipated monetary stance.

Interest rates are unlikely to leave the zero-lower bound (ZLB) without a major growth or inflation surprise, so it will be up to fiscal and monetary cooperation to manage the next cycle. Central banks will be unable to provide interest rate cover, and it is highly likely they will have to money finance a fiscal expansion.

A major change in the balance between monetary and fiscal policy will likely lead to a major change in market risk-return assumptions and investment beliefs. Volatility will be the inevitable result as investors struggle to understand what this means for risk-seeking behaviour. Investors need to review their assumptions and investment beliefs to make sure they are fit for uncertainty and fit for purpose.

Policy has Encouraged Risk

The return on risk-free assets has been suppressed in the past ten years by large central bank interventions, through balance sheet expansion and maintenance of policy interest rates close to the ZLB. Investors have had to reach out along the risk curve and must take additional risk to earn return above the risk-free rate. Yet the return on risk has been good through this period, as central banks have also suppressed volatility to encourage that risk taking.

However, as the expansion of the Fed’s balance sheet has ended, volatility suppression has ebbed, but the reach for yield continues and investors are taking-on an additional increment of risk to reach their goals.  Investors are likely not fully aware of the risks they are taking.  

The popularity of private debt today illustrates this. Investors are attracted by the high returns of illiquid private debt relative to liquid public debt, and while investors may be aware of the credit risk they face during the lock-up period, and while they may have accepted that they cannot sell-out of the position to avoid anticipated losses, they may not have received sufficient reward for that risk. 

Fear, Market Timing and the VIX

Pricing of risk is crucial to making the right decision. The S&P500, the most watched US equity market index, has a related index of risk called the VIX. The VIX is an index of implied option volatility on the S&P500 and is an exchange listed vehicle. Through the period of central bank intervention, both realized volatility and the VIX were low. 

The VIX index is popularly known as the “fear” index, and the market often looks to the direction and level of the VIX as a proxy for the degree of market risk tolerance or aversion. This belief is likely misplaced, and reflects a tenuous application of the VIX to aid in market timing. All the VIX does is tell us about the pricing of the expected volatility of the S&P500. 

A given level of the VIX doesn’t really tell us about fear or sentiment about market direction; rather, it is a forward-looking price of expected stock price volatility. The VIX indicates the cost of hedging risk that is consistent with observable market prices. And, by examining past values of the VIX, we can get a sense of the cost of implied volatility today compared to that in the past.   

Some players view very low levels of the VIX relative to history as saying something about the overall valuation of the S&P500. For example, a VIX that is low relative to history might imply the market looks ripe for a downward correction. A VIX that is high relative to history, might imply the market is offering upside value. Taking market-timing bets on the level of the VIX relative to history is likely to prove unreliable, and if it were reliable then investors would arbitrage those signalling properties away. 

Value and Risk Intimately Paired

Value and risk are related; risk is return’s evil twin. We think of a market as offering good value when the price is lower than its average, or has reached some long-standing indicator of worth. Similarly, when the price is higher than its average, or it has reached some other long-standing measure that says the price is high, then this is an indicator of poor value.

Adding risk into the value calculation suggests that when value is good, the risk of loss is low, and when value is poor, risk of loss is high. So, investors really need to combine the level of the VIX with value measures of the S&P500 if they want to get a sense of the overall balance in the market between expected return and the pricing of risk. 

If value is poor and market prices are high, risk of loss and potential scale of loss is big. So, if the corresponding VIX level is low relative to history it is likely telling you that risk is reasonably priced to hedge, not that an adjustment is imminent. 

The key point is that market timing is a poor way to manage risk, and that is not a role for which the VIX was designed. Instead, the risk is best managed using tools that are specifically designed for that purpose, that are agnostic on market timing, and that are embedded into careful portfolio construction.   

Reaching for the Efficient Frontier

In the investment world, there are assets and there are investment styles. Modern Portfolio Theory (MPT) posits that the only free lunch in investing is diversification. Risk diversifies and returns add-up. Assets are combined to maximise the diversification effect, or a reduction in risk that does not sacrifice return.

Diversification and de-risking are two different things. The diversification benefit derives from stable correlations between asset and style return streams. The smaller the correlation the better the diversification. But return volatilities also matter. Even if stocks and bonds are perfectly negatively correlated, the fact that equity returns can decline more than the offsetting increase in bond returns means that a portfolio may not be as diversified as an investor believes.

Many portfolios are not as diversified as investors believe because the returns of uncorrelated assets often have very different volatilities[1]. Investors can increase the weight of the low return volatility asset and reduce the weight of the high volatility asset to achieve better diversification, but when they do they reduce return. They have not achieved a better diversification benefit, because return has fallen along with the reduction in risk. 

The search for additional diversification beyond asset combinations, and changes in asset weights, leads investors to embrace active investment styles.  There are essentially three active investment styles: value, momentum and carry. Investors can add one or all of these investment styles to find a better point on the efficient frontier. Or, put another way, they find as many non-correlated strategies as they can to maximize the diversification benefit.

Assets and styles need to be combined strategically in the MPT space. Find the point on the efficient frontier you like and stay there. Implicitly MPT assumes a long investment horizon so that investors can ride out correlation instability as actual return correlations can be different than expected return correlations. But not all investors have a long or infinite investment horizon, so drawdowns matter. Investors are often unaware of the importance of drawdown management and protection. In constructing their portfolios, investors should value long volatility exposures that provide them with positive returns when correlations and diversification break down.

Volatility is not the Same as Risk

Volatility can be thought of as a process that defines outcomes that are different than expected. This is quite different than how volatility is defined and deployed in MPT and portfolio construction. MPT describes volatility as the dispersion of returns around some mean, or average, over time. 

Volatility is also equated with risk. While risk and volatility are related, they not the same thing. When we say risk, we mean risk of loss. Dispersion may tell you what potential negative return you may experience. Loss is when you crystalize that volatility by exiting the asset at the lower end of its return distribution as you meet your loss tolerance and sell.   

A volatility manager is acutely aware of the dangers of risk of loss, and its potential cost, and so thinks of “volatility” as something that can be managed and mitigated. The volatility manager positions to do so. This comes at a cost, but when an investor covets better quality returns than merely rolling the dice to get the highest return, it is a cost they are prepared to pay.

Volatility managers identify the lack of asset and investment style return correlation stability as a reason to include “Vol” strategies as an input to portfolio construction. Asset return correlations are demonstrably not stable through time. This is especially so in times of financial and economic crisis. 

All financial crises can be traced to a failure to provide for liquidity. When the returns to liquidity are high, diversifying correlations disappear as all assets are sold to raise liquidity[2]. The volatility manager focuses heavily on this phenomenon, have a vested interest in educating investors to the risk, and encourage them to prepare their portfolios against the downside.

Artemis Capital Management has defined volatility in the following way. “Volatility alters a portfolio, not by making money all the time, but by improving the risk-adjusted efficiency of other assets, and creating new opportunities in bear markets”[3]. If investors can find an investment vehicle that delivers on this investment intent, then inserting long volatility exposures in the portfolio will shelter it in times of crisis.

Inclusion of long volatility exposures does not seek to find a better diversification benefit: rather, they are insurance against correlation breakdown. When volatility strategies are combined with existing market or style exposures, they can both improve the quality of the returns, and if done expertly can improve overall returns when measured over long horizons. 

Despite the investment industry focus on the quality or efficiency of returns, many investors focus exclusively on the quantity of returns even though they are aware that a future loss can be severe. They are simply not prepared to sacrifice some returns in good years to protect them in the bad years.

Knightian Uncertainty and Policy Change

There is a difference between risk and uncertainty. Risk is when you can quantify an investment – where you can balance expected return with expected volatility. You forecast both the magnitude of expected gain, and the magnitude of the potential loss. You can also assign probabilities to either state and so are comfortable with the position you have. You think that either the balance of expected gain or loss works in your favour; or, the balance of probabilities is tilted in your direction.

In normal, risk-seeking market environments, prices can be easily discovered, and move very little during transactions. Risk can also be priced, and unwanted exposures hedged. However, when uncertainty prevails, price discovery is difficult, hedging becomes both harder to accomplish and more expensive, with transactions prices often dramatically wider. 

Knightian uncertainty is a state where not one aspect of the investment calculation is possible, and investors gripped in a state of uncertainty are rendered unable to make investment decisions[4]. 

Owning Volatility Prepares for Uncertainty

In times of acute crisis, market making capacity breaks down, as demonstrated dramatically in the great financial crisis of 2007-2008. In such times, the value of volatility protection becomes the price of uncertainty, and this is worth paying-away in the good times to get you through the bad times.  Because once the bad times are here volatility protection is nearly beyond reach. 

Investors have had a good run since 2008. To get significantly large returns relative to risk-free interest rates hovering close to the zero-lower bound, investors are taking more market risk, liquidity risk, and credit risk than they realize, and for which they are potentially under compensated. Value cannot be determined without a measure of risk.

Central banks have been very helpful in keeping the momentum-driven market going; they have been volatility crushers. But monetary policy drivers and its parameters are changing, whether that be the current and willful disruption to international trade, which if pursued to the limit will deliver a negative productivity shock, or the future balance between monetary and fiscal policy. 

The foundations of our economies are shifting, and our own investment beliefs and assumptions need to be tested and reformulated as the policy and investment regime changes. The changing balance between monetary and fiscal policy means that we cannot assume that in the next downturn and crisis central banks will be able to suppress volatility and boost risk-related returns a second time.

 These changes are already underway, so now is the time to focus on securing good quality returns rather than stretching ever further for the highest return without regard for risk. 

[1] Between January 1990 and December 2018, the annualized standard deviation of S&P 500 returns was 14.2%, but the same measure for bonds as captured by the Barclays US Aggregate Bond TR Index was just 3.6%.

[2] The return to liquidity refers to the large potential gains available after a major downward price adjustment. Those return are only available to investors that have, or can raise, the necessary cash to invest in the undervalued asset. 

[3] Christopher R. Cole, Artemis Capital Management, April 2016.  Artemis Capital Management is a specialized investment and research firm. 

[4] Knightian uncertainty is named after University of Chicago economist Frank Knight who drew the distinction between risk and uncertainty by defining uncertainty as a state of the world that cannot be quantified. See Risk Uncertainty and Profit (1921).