08 Feb 2018

Passive-Aggressive Behavior in Equity Markets

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Mustafa Sagun, Chief Investment Officer, Principal Global Equities
by Mustafa Sagun, Ph.D., CFA , Chief Investment Officer

What the heck happened to the equity markets?

Everybody was enjoying a smooth ride. Volatility was at historic lows. Markets were near all-time highs. Then, we had a flash crash of sorts. Similar to the analogy of the fat, happy, turkey the night before Thanksgiving, what a difference a day makes. On Monday, the S&P 500 Index sold off 4.1%. The impact on volatility was even more pronounced. The CBOE Volatility Index (VIX) looked like an EKG chart during a heart attack, jumping abruptly to 50 for the first time in over three years. Drama aside, what happened?

Heart attack shift in volatility

The recently placid VIX roared to life in February, surging to 50 for the first time in years

CBOE Volatility Index

CBOE Volatility Index

Source: Bloomberg

For some time, I’ve been warning investors about the potential dangers lurking in passive investing, specifically, in non-price-sensitive investing in general. Many popular volatility-hedged, volatility-targeting, and risk-parity approaches share a worrisome characteristic: they become forced sellers as volatility increases regardless of price or fundamentals. On Friday, February 2, as intraday volatility started to rise, we saw evidence of gamma hedges becoming negative. Hedged portfolios started to be exposed more to declining market prices and increasing volatility. This required their managers to sell liquid instruments such as index futures, options, and ETFs to adjust the hedge. That’s when the trouble really started. In really layman’s terms, the hand that consistently brought food to the turkey showed up with a knife.

Liquidity has a price. People who think passive and other non-price-sensitive investment strategies “reduce risk” will see that the price of liquidity is most dear when times are most dire. This is often why the most liquid market segments suffer more than expected during such corrections, because the price you can get depends on who is on the other side of the trade. This conundrum makes fundamental managers very important to the market.  They can spot value that passive strategies ignore, and step in to provide liquidity when it’s needed. Without fundamental investors in the market, you pay a very high price for liquidity when it is most wanted, as we saw on February 5.

What is our outlook? The investment team at Principal Global Equities believes this recent market drop is a merely a correction, and that it will stay a correction, because the company earnings are strong and supportive of further economic growth. There will be more fundamental liquidity coming to the market to stabilize since active managers are constantly on the hunt for companies with strong earnings growth at attractive prices. However, it seems like we have moved from a low-volatility environment to a higher- volatility regime.

Estimates put the total assets deployed in non-price-sensitive strategies at nearly $1 trillion. That’s $1 trillion that can contribute to more volatility spikes and market corrections because these strategies de-risk using rules-based trading algorithms. If you were investing back in 1987, this might sound like the “portfolio insurance” debacle. While technology and trading vehicles have evolved, the basic problem is the same: liquidity stress. Make no mistake, the recent correction was much more of a liquidity shock than a fundamental shock. 

Of course, the biggest risk comes when liquidity shocks occur amid material economic and earnings downturns. At present, our team doesn’t see evidence of such conditions; earnings trends remain strong and supportive. In short, the correction serves as a timely reminder of the value of downside risk reduction in the form of active, fundamental investing.


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