Capital markets have been extremely challenging for the institutional investor over the past 18 months. Even parties that had set their minds on sitting out the volatility on the basis of being a long term investor are starting to reconsider whether sitting tight and do nothing remains the best course. Indeed, looking at some basic data, it is hard to deny that we live in a totally different world compared from 18 months ago. The VIX index, often referred to as the “fear-index”, measuring investor assessment of the riskiness of the stock market reached the unprecedented level of 80% late November, the highest reading in its 18 year history and well above past peaks of 40-50% seen at previous instances of market stress such as during the Asian crisis, the LTCM crisis or just after 9/11.
Clearly no other conclusion can be drawn than that the market is living in a state of fear after having lived in a state of benign tranquility for the best part of 4 years leading up to the first signs of sub-prime trouble in July 2007, when the VIX was hovering just above the 10% level. From a risk-budgeting perspective a rudimentary calculation would say that if one held 40% of equity in portfolio 18 months ago, the non-diversified risk contribution would be 40% of the 10% market risk implied by the VIX, or 4%. Late November the same allocation would constitute a whopping 32% of risk, given where the VIX traded at that point in time. To make matters worse, the above calculation disregards the benefits of diversification which have dissipated in the recent market turmoil. Diversification benefits would have meant the 40% equity allocation 18 months ago would have added much less than 4% to the total risk of the institutional investor’s portfolio. Let’s assume the marginal risk contribution would have been 2%, so half the level of risk in a fully correlated world. If correlation would have remained low the equity exposure under the new high-risk market regime would bring on 16% of risk into this investor’s portfolio, but as correlations have risen dramatically the actual risk contribution could well be close to the 32% of our rudimentary calculation: a 16 fold increase in risk brought onto our investor’s portfolio only by market forces, without any explicit action on its part.
The variability in the VIX has also risen spectacularly and this increase in the volatility of volatility itself makes budgeting for the risk exceedingly difficult. An investor could adjust its portfolio if it knew volatilities had tripled and correlations had doubled, but if these variables are unstable and move all over the place, the scientific approach to risk-budgeting breaks down altogether.
Where does this leave actual institutional investors such as the typical pension fund in Japan ? A recent study by JP Morgan suggests a lowering of equity allocations, in particular domestic equity to reflect the heightened (perception of) risk, with alternative assets being the main beneficiary of this shift in asset allocation. Traditionally the alternative asset bucket for Japanese pension funds has been dominated by (fund of) hedge fund investments whilst asset classes such as private equity, real estate and infrastructure, the core of alternative assets in European and North American pension fund portfolios, have been relatively under-represented. In the current market environment, the fact that these asset classes are somewhat shielded from the daily price action of public markets makes them look attractive on a comparative basis. Simultaneously, the experience of Japanese pension funds investing in (fund of) hedge funds has been ambiguous. Most of these investments have been undertaken as an alternative to domestic bond holdings, the argument being that with ultra-low yields on JGBs the only way for these yields was to go up and it made more sense to divert assets into low-risk hedge funds which would make 3% or 4% returns in yen and wait for JGB yields to rise before taking renewed exposure to domestic fixed income. In hindsight however JGBs have been the best performing asset class in Japanese pension portfolios and the hedge funds that were meant to be low-risk/modest-return turned out to show draw-downs exceeding the comfort level of many a board of trustees. It is one thing to record a 15% loss on one’s investment if equities are 30% in the red and the investment was placed in the equity bucket, it is quite another if it was meant as a surrogate for bonds that are recording positive returns over the period.
Meanwhile the more sophisticated plans are tackling the rise in correlations between virtually all investments that contain risk of some sort (ie virtually all mainstream assets available thus far in financial markets) by seriously looking into un-chartered new assets. Insurance related risk is an area of interest to some: the fact that the turmoil in financial markets has been accompanied by an unusually mild hurricane season has not been lost to some. Volatility itself is one such area where hindsight tells us that it would have paid to be long 18 months ago when it was cheap. Maybe the next big trade is to be long the number of empty containers in the port of Shanghai and short the hedge fund manager bonus-pool.