It is a truism of the financial markets that when interest rates are too low, investors inevitably take on all sorts of silly risks in an attempt to earn a little extra return. And inevitably there is no shortage of financiers ready to sell them “innovative” new investment products that promise to earn them that extra return for no extra risk.
Usually these products pass under the radar, only coming to light when market conditions take a turn for the worse and they blow up in spectacular fashion, taking all their investors’ capital with them. We saw this in the 1987 crash, and again in the 2008 financial crisis, with all the “collateralised debt obligations”, minibonds and other arcane structured products whose value promptly fell to zero.
We’ve seen it this week too. Market traders tell how the sell-off was amplified by algorithm-driven, or “algo” trading programs, which use vast computing power in an attempt to spot and exploit hidden patterns in market moves. Well, they spotted that prices were falling and instantly started to sell into the falling markets in huge volumes, greatly exacerbating the sell-off in much the same way that “portfolio insurance” programs exacerbated the 1987 market crash, inflicting heavy losses on the very portfolios they were meant to insure.
This round of sell-off has also highlighted the shortcomings of “risk parity” investment strategies. These promise to juice up returns for the same level of risk by balancing the volatility exposure of different, inversely correlated assets. Typically they seek to balance equity risk with leveraged positions in bonds. In recent years the strategy has worked well. But this week the inverse correlation between stocks and bonds broke down as both fell together. That sent risk parity managers scrambling to reduce their exposure, once again selling into falling markets in a self-reinforcing feedback loop that is rumoured to have seen many portfolios suffer major losses.
But perhaps the most lunatic new products whose existence was highlighted, and in some cases abruptly terminated, by last week’s turbulence, were exchange-traded notes that allowed investors to speculate that volatility in financial markets would only fall. In effect, these sold options contracts on the Vix index of US stock market volatility that is itself derived from the expected volatility levels implied by the prices of options on the US S&P 500 index.
So, investors were selling options on options – not running double the risk, but stock market risk squared. It’s a strategy that has actually appeared to work quite well. Because central banks have been printing money, all the liquidity they created squeezed the volatility out of financial markets, with volatility falling to record lows last year. But it was a classic example of the sort of trade that has been likened to picking up pennies in front of an advancing steamroller. You make modest positive returns, until all of a sudden you get squashed.
Unfortunately, investors in these products either failed to understand the level of risk they were running, or they had a very poor knowledge of financial history, which teaches that sooner or later, volatility always spikes. That’s what happened this week. The S&P 500 fell a few percentage points, implied volatility tripled, and at least a couple of inverse volatility notes lost more than 95 per cent of their value in just a few hours of trading, losing billions of US dollars.
Where money is concerned, some people never learn.