A view from the equity market

  • The collapse in the “greed index”, the exchange traded note XIV that was an inverse of the VIX, was behind the speed and magnitude of the drawdown in equities over the last week, but was simply amplifying an existing fragility that has grown out of the post GFC obsession with low volatility
  • Just as an obsession with index tracking pushed first Japan and then a decade later the dot com Nasdaq to ridiculous boom bust behaviour, so its replacement, an obsession with low volatility, has given us the CDS market in 2007/8 and now a decade later a vicious unwind of low volatility strategies
  • This is market mechanics. So far fundamentals are unchanged, but it is to be hoped that it may prompt a focus on the overlooked risk factors that really matter to long term investors; liquidity, leverage and of course credit risk

Sometimes “an accident waiting to happen” actually does and so it proved last week with the XIV low volatility trade that we have been discussing as a market risk factor on and off for over a year now blowing up and triggering a dramatic roller-coaster ride for equities, particularly the S&P 500. By now, almost every market commentator has discussed the mechanics of the XIV trade, much as armchair sports fans rapidly become experts in minor Olympic sports within 24 hours of their national teams getting to the finals, so I won’t go into great detail here other than to highlight that these low volatility exchange traded notes (ETNs) significantly amplified a relatively ‘normal’ market adjustment.

I have been in Australia this week, speaking once again at the annual Financial Standard Chief Economists’ Forum in Melbourne and Sydney, where 5 speakers get a chance to air views for the year ahead in front of a combined audience of around 1000 people, although I obviously make it clear that I am there as an investor rather than a Chief Economist! One point that I like to make is that macro views are often the most consensual and the most persuasive right at the top, when everyone is bought into the story. This is particularly true in my opinion in what I refer to as the ‘noise’ markets of currencies and commodities, which I see as tradable prices rather than asset classes in their own right. As I pointed out last week in Market Thinking, this time a year ago, the speculative consensus was long dollar and long oil on the “Trump trade”, neither of which turned out very well, while this year they seem to still be long oil and commodities on a cyclical growth story, but now short the dollar and in particular long the euro. This is not to be aggressively contrarian, rather to say that it may well be in the price. I also pointed out that in asset classes, the consensus a year ago was heavily underweight emerging markets and China, where a contrarian view really did pay off and that even this year, most international investors are at best lukewarm. Of course my top anti-consensus pick last week - and of course when I prepared my slides - was to buy puts on the S&P 500, which by the time it came to the presentation in Sydney on Thursday looked like some fine hindsight investing!

Readers who saw the last report will note however that while I did regard US equities as a consensus long, the rationale for puts was not so much being a contrarian as based on the margin financing and other leverage that had come into the US market since the start of the year, making the year to date rally look very fragile. (It was a similar observation of leveraged buying that made me particularly concerned about bitcoin just before Christmas.) In addition, the manner in which traders had chased call options and sold puts meant that the cost of hedging (buying puts) was actually extremely reasonable. My suspicion therefore is that I was clearly not alone in noticing this and that it could thus have been a pickup in buying puts that prompted the spike in the VIX which then in turn triggered the meltdown in the inverse VIX ETN, our old friend the XIV.

This has been what I would regard as a classic case of market mechanics - distressed sellers and forced buyers (in this case with a powerful feedback loop between the two) are in my experience almost always the reason behind dramatic market moves, rather than profit taking, or concerns about US bond yields or any of the more traditional explanations I have heard this week. The fact that the XIV actually went to practically zero and is thus no longer a factor in markets has certainly acted as a firebreak and VIX has now come right back down again and markets have stabilised.

So do we all just ignore it and go back to where we were? Or is the equity bull market over? These were the two questions most commonly asked over the last week. In fact, my answer has actually been no to both questions, since I don’t believe they represent our only options. I think equities still offer great opportunities, but I wouldn’t necessarily express that via the S&P 500 index. Partly this is because as I mentioned last week, non US equities are now the cheapest they have been against the US since 1997 and partly because the US now represents over 50% of global market cap, but I don’t believe it represents 50% of the opportunities. The dips I would be interested in buying would thus be stock specific rather than index based, because I do believe that we are in a structural shift away from passive investing in equity benchmarks. Those who operate on historical behaviour of bond and equity markets need to recognise that the investor base is very different from the past and growing ever more so. Many of the big institutional investors are now constrained by macro-prudential regulation and asset liability systems so as to be able to hold very little in the way of equities, while the shift from property and cash towards a more diversified portfolio amongst the booming middle classes of Asia means that western bond and credit markets offering sub 3% yields are still of very little interest and would be even at 5%. There is also a home market bias effect. As we often point out, Asian equities pay 25-30% of all dividends globally yet barely reach 3%, let alone 5% of most global portfolios. An Asia based investor would probably start at 40%. Moreover, the binary notion that they can own either a standard bond index or a standard equity index will likely not appeal either, partly because the indices themselves can be quite skewed to particular stocks or credits and partly because people used to buying ETFs recognise that to get a benchmark level of return they need to accept a benchmark level of risk. If you want to accept only half the risk, you need to accept half the return, but that may well be acceptable. However, it is also perfectly possible to construct strategies that do this by stock and credit selection rather than complex and often expensive hedging overlays.

This all brings me to my final point on this short (in flight) note. Perhaps the events of the last week will be sufficient to trigger some questions around the wisdom or otherwise of complex investment structures and a return to more simple, active investing, with a focus on broader measures of risk other than simply volatility? If we remember last time a market was over 50% of global market cap, as the US is now, it was Japan in the late 1980s and back then the risk obsession was index correlation. Investors were told that the best way to reduce the risk in their global portfolios was to have 50% in Japan. Obviously we know how that ended, but we still found ourselves in the dot com bubble a decade later with investors chasing market cap. Indeed small free floats and the notion that big index focused investors would become forced buyers was a deliberate capital raising tactic. The peak of this of course was the same risk management advice that you would minimise your risk by having five times as much of your portfolio in Cisco as you did in Berkshire Hathaway. Not wishing to get fooled a third time, we thankfully gave up on index tracking and indeed a simple strategy of equal weighting hugely outperformed in the following decade, which of course is why almost every smart beta strategy seemingly worked, all the heavy lifting was done by the non-market cap weighting. Chart 1 shows how after we abandoned market cap weighting, a simple strategy of buying an unweighted index of the S&P 500 stocks outperformed the market cap weighted index by 70% over 5 years. If we think about that for a moment, it seems to consist of no stock picking skill at all (same stocks) just walking away from the previous orthodoxy.

Chart 1: Five years after the dot com bust, simple equal weighted strategy outperformed

Source: AXA IM (from Bloomberg data), February 2018

My point is that perhaps it takes two blow ups to shift the models? Following the dot com crash and the abandonment of the apparent  false gods of correlation, the risk models shifted to focusing on the other component of CAPM (capital asset pricing model), volatility, as our prime measure of risk. In part this came from regulation and in part because, like correlation, it was relatively simple to measure. Whatever the balance, the financial service industry worked both to demand and supply so called low volatility products, culminating in the credit default swap (CDS) debacle that became known as the financial crisis. This again was much more about market mechanics than economics - although many economists made a lot of money for a while by claiming they had forecast the crisis on account of their bearish views on the US housing market. Equally the traders who actually did make lots of money did so because they understood the inside workings of the market structures - an assertion I would back up by pointing to the distinctly ‘patchy’ performance of most of these investors when they subsequently tried to apply their ‘macro-economic insights’ to other markets. The parallel with the experience of the 1990s is that just as the response to a failure of market cap weighting in Japan was to create a different market cap weighting problem in Nasdaq, so the response to the false promise of low volatility products that were regarded as low risk right up until someone tried to sell them in my view seems to have been to create a different set of low volatility products.

This is not to say that we will get a 2007 style crash, rather to suggest that last week might be something of a wakeup call as to the wisdom of accepting that volatility is a sensible measure of underlying risk, let alone the only measure. Equity like returns with bond like risk has been the mantra since 2009, which has delivered lower volatility for sure, but also delivered rather lower than equity returns. Moreover the realisation that this low volatility - which is actually not a risk a long term investor needs to particularly worry about (in contrast of course to a trader)  - has not only reduced returns but has come from a complex set of financial products that require not only lots of leverage but also increasingly an acceptance of a significant loss of liquidity. With quantitative easing winding down, the cost of carry rising and very high valuations (low yields) in many of the underlying ‘low risk’ assets, long term investors may start to recognise that liquidity, leverage and of course credit risk are the risk factors that they should perhaps focus more attention on.

This would mean a back to basics approach of looking at credit risk, balance sheets, underlying cash flows and cash flow projections, avoiding benchmark tracking and running active equity and credit risk. But then I guess I would say that wouldn’t I?

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