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April 15, 2007

Volatility Management in a Complacent World

Volatility has a corrosive effect on returns. Two cash flow streams that generate similar average returns, where one is more volatile than the other, can result in sharply divergent IRRs with the less volatile stream yielding the superior result. Therefore, it is clear that volatility reduction has a real and calculable value, but requires a probabilistic view of the world that is often difficult to quantify and harder to pay for. Further, sometimes the pressure for short-term returns can skew rational long-term thinking, causing an increase in the willingness to accept volatility that, in turn, further depresses the value of accepting such risks. And with this the cycle of complacency begins, is reinforced, and feeds on itself until the inevitable happens: event shock. And people will throw up their hands and say “Look at this tail risk; this is once-in-a-(decade/century/millennium) event.” And those with a keen appreciation for such things will say - I told you so. “Fat tails” and “three sigma events” are now and have always been a relatively ordinary phenomenon. Tail risk is risk that can and should be priced and, depending upon your objectives and stakeholders, actively mitigated. But this requires discipline and cost, two things commonly lacking in those compensated for short-term objectives. And herein lies the issue.

The Economist has an interesting piece titled Sting in the Tail, positing whether low volatility is making the world too complacent about risk. There are some derivatives details in the article that I will address in a separate post that are either unclear or incorrect and, in my opinion, confuse the issue and muddy the picture unnecessarily. However, the questions raised by the article are spot on and important for investors and policy-makers to consider.

The International Monetary Fund’s latest semi-annual Global Financial Stability Report
is sanguine about concerns such as the American housing market. But it
frets about a potential “volatility shock” in the financial system that
could “precipitate sharp portfolio adjustments and a disorderly
unwinding of positions,”—or, in other words, a panic.


The fund suggests the low volatility of recent years may be owing to
greater economic stability, improved central-bank credibility or the
better dispersion of risks around the financial system. But part of the
explanation could also be cyclical, notably abundant liquidity, low
borrowings by companies and high risk appetites.


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The IMF is unconvinced. It detects a
worrying sign of complacency—“tail risk” in the options market. Ever
since the crash of October 1987, when Wall Street fell nearly 23% in a
day, investors have been sensitive to the risk of an extreme fall. They
have been willing to pay a higher price (as measured by implied
volatility) for extreme out-of-the-money options than for contracts
that insure against smaller market declines. But this premium has been
declining sharply in recent years. In other words, investors are
becoming less worried about extreme events.


Since 2003, being blasé has been the most profitable strategy. Risky
assets have performed well; for example, the spreads on emerging-market
debt recently hit an all-time low. Market shocks have been subdued.
Even February 27th’s 400-point fall in the Dow Jones Industrial Average
came low down the historical league table of percentage daily falls.


But what might cause risk appetite to change and volatility to soar?
The simple answer is Harold Macmillan’s phrase, “Events, dear boy,
events”, perhaps some geopolitical incident or unexpected corporate
failure. Emerging-market debt would be a big casualty of such a shift.
The IMF reckons that, if volatility moved
to two standard deviations above its post-1990 average, emerging-market
debt spreads would more than double. Something to worry about indeed.

This interesting piece neatly raises at least five important issues that need to be considered as it relates to volatility and its relevance for investors and fund managers alike:

1. Have developments in the global financial markets - the rise of derivatives and risk dispersion, stronger, more competent central banks, and a more diversified base of economic power spread across countries, companies and currencies - conspired to reduce the “structural” level of market volatility?

I think the answer is yes. In general, diversification reduces the variability of outcomes, and with the increased diversification of both risks and economic power it must logically follow that some degree of variability has to have been stripped from the global financial markets. This doesn’t mean that markets still can’t get pushed out of whack or that exogenous, non-economic shocks (i.e., war, terrorism, etc.) don’t have profound economic impacts that give rise to volatility. It only means that if one were to take a longitudinal view of global economic performance, that one would expect a less variable set of returns than previously generated in a world with greater concentration of risks and economic power. My only qualifier to this is: in a more complex, diversified world, does this possibly give rise to a third dimension of exposures related to the non-linear increase in the complexity of relationships managing the world’s global economic resources? It was easy to navigate when you had a few economic superpowers and a few powerful financial markets. But what about now? The picture is painfully more complicated. And this might, in and of itself, effect the volatility landscape.

2. Are the perceptions of risk and, therefore, volatility, cyclical?

The answer is unquestionably yes. People and markets have short memories, and that is a fact. Which means that if liquidity is plentiful, spreads are tight and investors are looking everywhere for returns, spreads will continue to tighten as previously risky assets are no longer viewed as risky (i.e., high-yield debt, emerging markets debt and equities, etc.). This also means that those buying insurance are few and those selling insurance are plentiful, further depressing volatility and only amplifying the effects of a complacent market psychology.  Then seemingly out of nowhere - bang! Emerging markets debt spreads move from 200 bps to 1000 bps, equity markets drop 10-20%, and risk premia magically expand to meet the heightened anxiety and uncertainty. And this will persist for a while. Until people forget about the shock and it’s once again business as usual. This is how it always has been and this is how it always will be. Will the current liquidity-fueled securities-buying boozer persist indefinitely? Of course not. It is just a matter of time.

3. Are the costs of insuring against tail risk relatively expensive?

Yes. And they always will be. Selling out-of-the-money put options is a risky business, and the implied volatility that is required to buy these instruments is generally very high. In fact, broker/dealers are not the ones best positioned to sell such instruments. While the implied volatility charged the buyer is relatively high the cost of the option is absolutely cheap, due to its out-of-the-moneyness and the low probability of its being exercised. Therefore, the broker/dealer selling the option is not making a whole lot of money even when charging high implied volatility, and the dynamic hedging (usually “delta hedging" - the probability-weighted amount of the hedge underlying that needs to be held based upon the spot price of the underlying and the remaining time to maturity) that needs to take place is subject to "gap risk." This basically means that when the dealer most needs to sell to adjust its hedge it will be forced to sell at progressively less attractive prices in a market meltdown. This is how dealers can lose hundreds of millions of dollars very, very quickly. However, insurance companies and others with durable, ultra-long dated asset portfolios can sell these options as a vehicle for enhancing returns (the flip side of covered call writing) without the need for dynamic hedging. Bottom line, implied volatility will always be high for these types of instruments, and necessarily so.

4. Can one generate seemingly superior short-term returns by avoiding the costs of insuring long-term risk?

Absolutely. Whether the investor is buying risky assets at progressively tighter spreads or selling optionality as a vehicle for collecting premium it hopes never to have to pay back (and then some), these activities generate returns that are relatively attractive when compared to common benchmarks. However, Mr. Market ensures that investors don’t get something for nothing, so when that “unexpected” shock occurs - spreads blow out, markets drop and margin calls come knocking - the benefits associated with making short-term numbers look good are generally far outweighed by the costs associated with the unwinding of these risky asset/short-option positions. Messrs. Meriwether and Niederhoffer know all about this. So let’s just say that investors should look pretty carefully at fund documents before investing, because often these documents give managers tremendous amounts of latitude, and one will need to dig pretty deep to properly analyze the quality of a fund’s earnings. Is it due to good securities selection or an increase in portfolio risk? This is the question the needs to be answered.

5. Has complacency driven this historical tightening of risk premia across markets, to the point where it is poised to explode in the face of said tail events?

Oh, yes. I think liquidity is a great thing, except when it causes investors to make irrational decisions. Chasing returns. Getting away from a fund’s mission. Assuming risks that are properly absorbed by those better able (and more appropriately positioned) to take them. And when the time comes, no amount of liqudity is going to buttress what looks like an inexorably declining market. Changes in market psychology can be abrupt and harsh. People and governments will move to the sidelines until the detritus is cleared, and this will take exactly how long? Who knows.

So where we are today is at a time when the costs of insurance are both relatively and absolutely low yet the urge is for investors to sell it, not buy it. Because short-term performance considerations (which directly drive most fund managers’ compensation, as well as the ability to gather additional assets to manage) can often drive sub-optimal portfolio decisions. And this is certainly not good for fund investors. And it is at times like these when the smart, savvy, long-term oriented managers with an appreciation for history take a contrarian position. And I might wager that this is precisely what is happening. We’ll see the wheat separated from the chaff in short order. Just wait and see.

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COMMENT:

AUTHOR: Cole Wilcox

EMAIL: cole@blackstarfunds.com

URL: 

DATE: 04/16/2007 06:59:24 PM

Excellent post, couldnít agree with your assessment more. 

The focus on short term performance is known as maximizing your arithmetic mean return, but mathematically, superior long term performance requires a focus on maximizing the geometric mean. The compensation structure on Wall Street does not pay a bonus to managers based on their future cumulative out performance; they pay based on what you did this fiscal year. This is known as outcome bias, which values the short term outcome over the long term expectancy or quality of decision. Prop traders and portfolio managers are not in it for the ìlong termî as they tend to move from firm to firm every few years, and are not paid to focus on the long term. They get rewarded for short term decisions which can only lead to long term underperformance. Until the investment management industry changes its compensation structure (highly unlikely) managers will continue make the rational self interest decision to focus on the short term and as a consequence under perform in the long term. On the other hand investors suffer from recency bias, the tendency to value recent performance more than historical performance and they make allocation decisions with this bias. This rewards managers who focus on short term performance with new investor money to manage. If you are an investor that does not suffer from this bias and want to outperform in the long term do not invest with managers who are caught in this vicious circle.    

Cole Wilcox

Managing Director

Blackstar Funds, LLC

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COMMENT:

AUTHOR: Laserlikefocus

EMAIL: laserlikefocus@gmail.com

URL: 

DATE: 04/19/2007 07:39:21 PM

Very educative article for a newbie like me. 

I am a bit intrigued by this comment though.

"Because short-term performance considerations (which directly drive most fund managers’ compensation, as well as the ability to gather additional assets to manage)…"

My question is why is this the case? I can understand the focus on short-term performance in trading desks of publicly traded banks (they have to release quarterly figures). But why are hedge funds compensated for short-term performance? Aren’t their investors supposed to be sophisticated and aware of the detrimental impact of volatility? Why has there not been a push from investors to tie payouts to long-term performance?

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 04/24/2007 02:05:15 PM

A good post with a similar topic 

http://thepriceofeverything.typepad.com/the_price_of_everything/2007/04/its_about_time.html

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