Our Low Risk (Low Volatility) World

In case you haven’t noticed — and I haven’t — we apparently are in a world of exceptionally low risk. To see this you need look no further than the volatility of the major markets. The volatility of the U.S. equity market, for one, is at its lowest level in a generation. So, no worries here, right?

I wrote a blog post in 2011 titled The Volatility Paradox which explained that when volatility is low, risk is actually rising because people are more emboldened to take on higher leverage and to move to riskier assets. If volatility is half of what it used to be, why not lever twice as much? Thus the immediate question is what happens if there is a sudden surge in volatility from our current, low level. What is the dynamic through which a volatility shock might propagate across the financial system?

A conventional stress test will assess positions that have explicit volatility exposure, such as positions in options, in the VIX and other volatility-based instruments. There is plenty of dry powder here; over the course of 2017, as the U.S. equity market volatility as measured by the VIX index dropped to one of its lowest points in history, we have seen a growing concentration in short volatility exposure by leveraged ETFs, mutual funds, and hedge funds.

But a stress test that does the simple mathematical calculation of direct portfolio exposure to volatility will underestimate the effect of a rise in volatility, because there are dynamics triggered by other strategies that do not have explicit volatility exposure but that have a link to the volatility of assets and to the assets themselves. A rise in volatility will trigger actions for these strategies, leading to selling of the underlying assets, and this in turn will lead volatility to rise even more, creating a positive feedback between the volatility of the market and the assets in the market.

What are these strategies? Well, a good place to start are volatility targeting, risk parity, and other strategies that will rebalance their portfolios when volatility rises. Volatility targeting is a strategy that targets a level of volatility to manage risk that is typically set based on the manager’s mandate. For example, the manager might follow a strategy that will seek to keep the portfolio’s volatility near 12%. If the volatility of the market is 12%, the fund can be fully invested. However, if the volatility of the market rises to 24%, the fund will sell half of its holdings in order to stay in line with its 12% target. Risk parity allocates portfolio weights to have the same total dollar volatility in each asset class. These multi-asset class strategies often use leverage to adjust holdings of underlying assets, buying more of the lower volatility assets relative to the higher volatility ones. If the volatility of one of the asset classes rises, the fund will need to sell some of that asset class in order to maintain equal dollar volatility. In both of these cases, there is a clear mechanism going from the rise in volatility to a drop in the underlying asset.

Things won’t all happen at once. The agents for these strategies differ significantly in their time horizon. Those who are directly linked to volatility, those that are in short-volatility ETFs and the like, will have an immediate P&L effect from a surge in volatility, and will need to reduce their positions immediately. The volatility targeters will only reduce positions as the rise in volatility is seen as having a non-transient component, and their adjustments will be in a weekly to monthly timescale.  And the risk parity agents will have an even longer time horizon, because they generally make asset adjustment with a monthly or quarterly time frame, and do readjustments based on a longer-term estimate of volatility.

Oh, a little more on the relationship between low volatility and risk: If you want to see really low volatility, look back at the swaps markets in the summer of 1998. But you might recall that in August of 1998 there was a rash of defaults in Russia, which was then followed by the blow up of LTCM, the (before that) famously successful quant fund whose principals a few months earlier had graced the cover of Business Week (never a good sign). In that case, low volatility didn’t spell low perceptions of risk, it was an indication that no one wanted to go into those markets because things were so uncertain. I go through my first-hand experiences with this in one of the chapters of my 2007 book, A Demon of Our Own Design.