Global Asset Management

True Partner article: Icarus versus Goldilocks

Page 2: The myth versus the fairytale


Buy-the-dip strategy is self-reinforcing until...

Market swoons are getting more and more short-lived. The anxiety is more focused on missing the low than on what drives the market downdraft to begin with. In the past 2 years, we have witnessed no less than five months which were characterized as volatile in the media. However, as the below table depicts, the actual degree of volatility increases as expressed by the VIX index and the front month VIX futures has declined over time. Compared to February 2018, the VIX Futures severely lagged in December, which indicated that the market was confident the burst of volatility was short-lived, effectively ending prior to the expiry of the VIX futures contract. Furthermore, in this year’s May and August, the VIX index spikes were more muted as well. In other words, banking on an ever more explicit ‘put option’ under the markets any downward movement must be quickly harvested through selling volatility and as a result volatility no longer ‘pops’. Therefore, the water looks tranquil beckoning more swimmers to come in the next time around. The increased competition mandates selling volatility even earlier into the decline in order to avoid missing out further reducing volatility and therewith yield of the strategy, a selfreinforcing increasingly crowded strategy.

Table 1: Peak closing levels in VIX spot and VIX future in recent volatile months

Table 1: Peak closing levels in VIX spot and VIX future in recent volatile months
Source: Bloomberg data


Low interest rate leverage is a two-way street.

In a low interest rate world, vast multiples are paid for earnings growth. Expansion of multiples such as price/earnings is in fact a leverage which has the power to magnify low growth rates into high valuation as long as yields and thus discount rates are low. Profits growing at 3% can carry a hefty valuation when your discount rate is 2%. But there is little margin for error as either a small decline in revenues or increase in costs can twist the pendulum into growth below the discount rate, a profit decline or even a loss. It is this dynamic that has caught many ‘boring’ stocks in recent earnings cycles with double digit percentage declines.


Trends are great until they ain’t

Volatility traders are not the only ones complaining. On the next barstool likely sits a stock picker lamenting the fact that all trends appear self-reinforcing and move away from their valuation logic. Some of these trends are driven by quants and algos. As in the fairy tale of the Pied Piper of Hamelin, profitable patterns attract more quants whose piling in further reinforces the trend, this way causing an extremely crowded trade. The ending to this movie we have already seen in the Quant Blowout of August 2007. This episode was overshadowed by the crisis shortly thereafter, but during a few memorable weeks, all the profits of year long following a popular trend were wiped out in a disorderly unwind. Perhaps it was the foreshadow of the GFC, a starting decrease in liquidity, which took the juice out of the trade. As ample liquidity spawns crowded trades, yet another painful unwind could be in the cards if the unprecedented current liquidity would get withdrawn.


ETF’s look liquid on the surface, but it is just an inch deep

One aspect of the above trends is the ease at which one can latch onto trends using ETF’s. The unprecedented migration from active to passive investing over the last decade has had the effect of more investors doing exactly the same. Equity index ETF’s have been mostly been extremely liquid, but this level of liquidity might not be present in the stock component of which the ETF consists. ETF’s tend to be market cap weighted, but for quite a number of components the degree of market cap vastly exceeds the degree of traded volumes. For those who want to practice, try trading Alphabet (GOOG) shares for size. In times of distress, when it really matters, liquidity is actually just an inch deep.

To illustrate with an example, let’s look at the MSCI Emerging Markets ETF (‘EEM’) during the ‘Taper Tantrum’ period in 2013. The market could not sustain the sudden larger outflows in EEM and during US trading hours the ETF traded at a significant discount to its Asian closing NAV. At the opening of Asian markets (where the vast majority of EEM component stocks were listed) this became a self-fulfilling prophecy as market participants would offload the underlying stocks at that discount, causing further declines and thus a negative feedback loop.

Another extreme example is that on May 6th 2010 (the Flash Crash) when basket traders ended up selling Accenture shares below USD 1, they earned money in that trade: they did so because their algorithm spotted a profit between buying the S&P500 ETF at a discount and selling the basket at the bid prices. The power of discounts in mainstream ETF’s cannot be underestimated. Since these two examples, the ETF market caps and therefore the stakes have significantly risen.


Volatility reducing strategies potentially create volatility

Markets are cyclical and people never learn. It is astonishing to see that renaming a product or strategy that failed in the past allows for the same mistake to be made again. Strategies which gear position size up and down along with market moves are effectively the same as Portfolio Insurance, which is widely believed to have exacerbated, if not caused, the 1987 market crash: increasing exposure in rising markets and low volatility is easy, but reducing exposure in declining markets and high volatility is not. This is especially the case if a strategy is leveraged and popular, hence ‘crowded’.

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