For the past two decades, the negative correlation between equities and bonds has been a gift for investors looking for diversification. Bonds have acted as a hedge during periods of stock market uncertainty, with weakening sentiment usually coinciding with falling expectations for interest rates and a consequent flight to quality. This mechanism hinges on the ability of yields to move so that bonds can achieve capital gains. However, with yields at such low levels, and little room for further interest rate cuts, the room for further compression is limited.
Persistently low levels of inflation have also contributed to the negative correlation between bonds and equities. Should current stimulus measures feed through into higher inflation, without an equivalent level of growth, this could indicate that something is fundamentally changing. The behaviour of markets is not fixed, although it can take a while for investors to change their habits.
We believe that alternatives are well placed to perform a similar role for investors, in terms of delivering uncorrelated performance throughout the market cycle. There are many alternatives, but an allocation to a ‘multi-strategy’ platform of market-neutral strategies combined with a protection strategy may provide an attractive alternative to a traditional bond/equity allocation, diversifying a portfolio with a greater range of potential sources of alpha.
In your 2020 outlook you stated that you thought volatility was underpriced and could rise in 2020. How did volatility perform in February and March?
Volatility is never a one-way bet, but it was our view at the end of 2019 that it had been significantly underpriced for some time, due to the prevalence of systematic volatility selling programs. The speed and breadth of the spread of COVID-19 in February and March saw a significant and sharp repricing of volatility, with markets understandably stressed and illiquid as economies around the world ground to a halt. Companies were laying off workers at an unprecedented rate, with business survey indicators for economic activity breaching new lows.
Systematic Long Volatility, which is a core component of our protection strategy, invests in equity index put options, with the aim to produce gains when either realised or implied volatility rises. In normal circumstances, such trades can be expensive to run, but underpriced volatility enabled us to build a position that we believed would deliver ‘crisis alpha’ at low carry cost. Option convexity of this sort performed exceptionally well in past risk events (such as Black Monday in October 1987 and the 2008 global financial crisis) and the scale of the move in volatility – as volatility sellers short-covered – ensured the COVID-19 crisis was no different.
Where are you seeing opportunities to buy or sell volatility today?
While we still see opportunities to buy volatility, the trade is no longer as lucrative. The markets have evolved to a point where the cost of carry (the total costs incurred to take an investment position) on a long volatility position strategy has risen commensurately with the level of current uncertainty, which leads us to look for other strategies to provide uncorrelated returns during such periods.
Our response has been to develop a flexible tail strategy that can be tactically deployed to maintain required protection levels during such times, when holding a long volatility position is expensive. The strategy is designed to capture as wide a series of shock events as possible, rather than just equity market risk, and can be switched off during periods of low volatility.
What’s the biggest risk in the market right now that you don’t think is being accurately priced in?
It is apparent to us that there is a disconnect between financial market pricing and what is going on in the real world at present. Governments and central banks have been complicit in creating this problem, with stimulus measures that have kept markets buoyant, while many industries continue to struggle with the ongoing fallout from COVID-19.
One risk that does not seem correctly priced into markets is the potential for stimulus measures to gain more traction than expected, causing higher inflation and impacting bond yields. Given the secular bull market we’ve had since the early 1980s, today’s investors don’t know how to handle a bear market for fixed income. As such we have taken a sizeable hedge against the risk of bond yields rising in the medium term, and will watch the issue closely.
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