Hedge Fund CIO: Wall Street Faces Profound Unintended Consequences From The Lack Of Diversification

From Eric Peters, CIO of One River Asset Management

Dusted off a Jan 2018 anecdote about the reflexivity in volatility markets. It’s something I think about when tracking cycle phases. Of course, the cycle that started in early 2020 is unique relative to anything seen for decades. The unprecedented policy response to the pandemic has forced investors to now build portfolios of risk assets without being able to rely on treasury bonds to materially offset the negative convexity. Consequently, the industry now faces an acute shortage of portfolio diversifiers at a time when it must take ever more risk to achieve its return targets (as noted earlier, JPM believes that consensus crowded trades are the biggest risk to markets as we enter 2021).

And the unintended consequences are as profound as they are not yet fully appreciated, let alone understood.

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Anecdote (Jan 7, 2018):

To sell implied volatility at current 50yr lows, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank eager to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by structurally decelerating global growth.

And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Also consider that investment banks and asset managers have always devised creative strategies to make money once asset valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated.

Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility has declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices.

This in turn reduces volatility, reflexively.

Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, this market is exposed to a historic reversal somewhere along the path to policy normalization. Which has now begun.

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ZH: Three weeks after this was published, during the February 2018 volmageddon event which wiped out numerous retail favorite inverse VIX ETFs, the VIX erupted the most in years after trading in the single digits for the longest period on record. The VIX is currently trading at 20, or roughly in line with its long-term average.

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