A World Of Suboptimal Choices

It’s never easy when bonds and stocks decline at the same time, but despite the much-publicized death of the “risk parity” strategy, I don’t think the past few weeks’ price action qualifies as decisive evidence. After all, the S&P 500 is down a mere 0.6% from its peak in the beginning of June, while US 10-year futures are off only 1.5%. In writing this, though, I remember that many punters in this business use leverage. This acts as an accelerant not only for the volatility of their PnLs, but also for the speed with which a meme can take hold in the peanut gallery.

I sympathize with the plight of bond traders in Europe where the dislocation in yields has been particularly nasty. When yields are near zero, or even negative, the relationship between small changes in yield and prices is brutal. This is even acuter in Japan, where the BOJ might soon have to actually defend that 0% target on the 10-year yield, to avoid an accident in the domestic asset management industry. In the U.S., the 10-year yields has been less dramatic, but big enough to raise questions about whether we have made a switch from a flattener to a steepener.

The combined woes of stock and bond prices arguably is the price we pay for seeing them go up at the same time on the wave of central bank liquidity. So, what are poor investors to do? 

Cash is a call option on volatility 

The plight of investors who find both stocks and bonds too expensive—or suffer when they both decline in value—reminds me of one former SocGen strategist Dylan Grice’s Popular Delusion notes from 2011 in which he makes “The case for cash.” Professional investors will be either seething or rolling their eyes at this point. Even if they wanted to hold cash, it is difficult for them to do so. Mr. Grice is well aware of this. 

Telling investors you find cash an attractive investment is about as big a faux pas as you can make. It might even be on a par with telling your wife her rear end looks big in those new jeans. Just because it might be true doesn’t mean you should say so.

Thus some of our clients are explicitly forbidden to allocate more than 5% of their portfolio to cash, while others with more flexible mandates nevertheless feel philosophically compelled to hold as little cash as possible. They feel that their clients don’t pay them to sit in a supposedly ‘dead asset’. But such mandates – perceived or real – effectively push investors towards owning risk assets at virtually any price, which is surely nonsensical. 

This is fundamental stuff in the world of investment management, but it also has profound implications. For example, the fact that most investors can’t sit on cash for longer periods offers investors who can a crucial advantage towards the end of the financial cycle, at least in theory. The money quote from Dylan’s piece is the following:

“Cash has one important endowment which is too frequently unrecognized: a hidden optionality derived from its relative stability. In other words, the holder of cash has an effective option to purchase more volatile assets if and when they become cheap. Thus, a willingness to hold cash when there are no obvious alternatives is the simplest way to ‘get long of the tails’, and therefore the original ‘long-vol’ strategy.”