08 Feb 2018

Passive-Aggressive Behavior in Equity Markets

Article Image: 
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.

Disclosure

Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of February 2018. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Principal Financial Group, Inc.,  Its affiliates, and its officers, directors, employees, agents,  disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document.

Any representations, example, or data not specifically attributed to a third party herein, has been calculated by, and can be attributed to Principal Global Investors. Principal Global Investors disclaims any and all express or implied warranties of reliability or accuracy arising out of any for error or omission attributable to any third party representation, example, or data provided herein.

All figures shown in this document are in U.S. dollars unless otherwise noted.

This document is issued in:

  • The United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
  • Europe by Principal Global Investors (Europe) Limited, Level 1, 1 Wood Street, London EC2V 7JB, registered in England, No. 03819986, which has approved its contents, and which is authorised and regulated by the Financial Conduct Authority.
  • Singapore by Principal Global Investors (Singapore) Limited (ACRA Reg. No. 199603735H), which is regulated by the Monetary Authority of Singapore and is directed exclusively at institutional investors as defined by the Securities and Futures Act (Chapter 289).
  • Hong Kong by Principal Global Investors (Hong Kong) Limited, which is regulated by the Securities and Futures Commission and is directed exclusively at professional investors as defined by the Securities and Futures Ordinance.
  • Australia by Principal Global Investors (Australia) Limited (ABN 45 102 488 068, AFS License No. 225385), which is regulated by the Australian Securities and Investment Commission and is only directed at wholesale investors (as defined in sections 761G and 761GA of the Corporations Act).
  • This document is issued by Principal Global Investors LLC, a branch registered in the Dubai International Financial Centre and authorized by the Dubai Financial Services Authority as a representative office and is delivered on an individual basis to the recipient and should not be passed on or otherwise distributed by the recipient to any other person or organization. This document is intended for sophisticated institutional and professional investors only.

In Europe, this document is directly exclusively at Professional Clients and Eligible Counterparties and should not be relied upon by Retail Clients (all as defined by MiFID). In connection with its management of client portfolios, Principal Global Investors (Europe) Limited may delegate management authority to affiliates that are not authorised and regulated within Europe. In any such case, the client may not benefit from all protections offered by rules and regulations enacted under MiFID.

This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc. and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.

©2018 Principal Financial Services, Inc. Principal, Principal and the symbol design and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. Principal Global Investors is the asset management arm of the Principal Financial Group.

Principal Global Equities is a specialized investment management group within Principal Global Investors.