Double, double toil & trouble…
This isn’t intended as a rant against the practice of diversification – nothing could be further from the truth. But, like all popular investment tools, there’s a mythology that’s been created around modern portfolio theory to suggest a panacea to cure all ills. It’s peddled as a fairy tale that ends with investor & portfolio happily ever after – together on a horse, riding off into the sunset. My argument is that the benefits of diversification depend on having appropriately calibrated priors. And when those priors are dramatically altered, it’s time to reassess – not double-down.
Imagine a world where equity prices were arbitrarily capped.
For example, a stock might trade at $146 & be “capped” at $200. Think about what you might pay for a call option on that stock that’s struck at $199.
Better yet, think about what you might SELL that call option for. Remember, the “caps” have never changed – in your lifetime & the lifetime of a generation of traders before you.
That close to the “cap”, your option model spits out something meaningless. It’s better to just do it by hand. For a 1-year expiry, you sell the call option for $0.50. The implied skew looks absolutely ridiculous at that level, but the buyer doesn’t care. They seem to know something you don’t. And they buy it. They buy a lot.
A few weeks pass & the worst case scenario becomes reality: the arbitrary $200 “cap” is moved – to $240. But that’s not all.
Every other stock immediately jumps above their previous “cap”.
You get a call from your operations team to inform you that the collateral being held against the option is, lo and behold, also just more of the same stock.
The government announces that they plan to fix the problem. They’re going to buy MORE of this stock. Not just a little, either – they’re going to buy up half the existing float. You have no idea how this is actually going to solve anything, but they assure the market that somehow this means people will want the other stocks instead & spout something about a “portfolio rebalance channel effect”. Whatever.
You frantically try to work out of your risk by buying up as many calls as you can, realizing that you’re paying multiples of the skew that you sold just a few weeks earlier.
You start thinking about how you are going to price more of these options, eventually you decide to just fool the previous model you were using into using the new “cap”. That doesn’t seem right to you, but it’s the simplest fix & you need a fix FAST.
It turns out, you don’t really need to bother. Your risk manager is standing behind you asking for your key-card & phone.
It also turns out, that’s not an imaginary world. It’s 2019 and that’s essentially what’s just happened in Treasuries. TLT at $200 is about where we’d land if US yields went where every other developed nations yields have gone.
But wait, there’s more…
Consider for a moment how you’d construct a portfolio in this environment. Is whatever original mix of equities vs bonds you were using still really appropriate? The expected return that you were anticipating for bonds is clearly much too low in an environment where the concept of “highest price possible” just moved 20%.
You don’t really have an option to diversify, either, since the new correlations that asset-classes & factors are trading at are close to 1. The only thing that’s even remotely close to an alternative still has an 83% average correlation to everything else & also just so happens to be the most volatile instrument on the board. That’s not an invention either – that’s what’s just happened as oil has essentially become the great diversifier.
If it’s felt like the recent trading environment has become a lot more directional, you’re not wrong. Asset-class correlations tend to rise during periods of market stress for the simple reason that the mkt switches rapidly between binary risk-on/risk-off environments. That why, in general, the post-crisis shift in asset allocation has been away from traditional “asset-class diversification” and towards “factor diversification” for the simple reason that it tends to reduce downside risks over long-term horizons.
However, most investors still tend to prefer what they see as investable “fundamental factors” – and this means using market-based proxies: for example, equities for growth, Treasuries for deflation, commodities for inflation, etc. That’s all well & good as long as correlations remain broadly anchored – but fails when they don’t.
But since the real world is rarely measured on such scales, let’s move away from “long-term/theory” towards “short-term/practice”.
Here’s what hourly asset-class correlations looked like last week.
For reference, here’s what the 3mth average looks like.
If it looks like this could cause a major problem for portfolio construction, you’re not wrong.
For equities, you can find some solace in trading factor-based correlations. But that’s not much help if you want to have some fundamental factor-based approach.
Furthermore, factor-based correlations don’t exactly look like a bargain either. The long-term trend-line is rising as well.
So, what’s the upshot?
If it feels like hedges have gotten awfully expensive, there’s a reason why. The demand will only continue to grow for alternatives as correlation across asset-classes & factors continues to rise: for example, commodities.
And if you decide to forego those hedges, just remember that the market-timing risk you’ve agreed to take on is pretty substantial. You’re going to have to time it perfectly. And that’s not a factor anyone should look forward to constructing a portfolio around.
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