INTRO
In our previous New Vol posts (New Vol – Part 1 & New Vol – Part 2) we concluded that the markets have taken over the economy and that a growing economy is now dependent on the markets rising. We also concluded that the symmetry between the inflationary and deflationary forces has been broken. We’ve been able to balance the extreme deflationary forces of debt with constant inflationary injections (QE). This balance produced an epic 10-year rally since the great financial crisis, but the balancing act is over. The Covid jolt and the massive move in rates have broken it.
The major tool to fight deflation has been the money printer and the creation of debt. Through the creation of currency units (QE), the world has kept rates artificially low. We choose the word “artificially” with great intent. Through QE, we are manipulating a web of complex systems as if we are in control. Due to the ever-growing forces of inflation and deflation, and due to the global nature of these issues, and due to the multitude of other systems and markets impacted (think interconnectedness), we need to be open to the thought that maybe, just maybe, we are not in full control. For this reason, we want to explore the concept of chaos and how it affects our portfolios, as well as our lives.
Let’s take things to the next level. Let’s assume we have entered a part in the story where things can spiral out of control. Let’s tweak the definition of risk, and instead of the risk being a decline in the markets it is something more (violently) systemic like the Ice-9 (a freezing of the system) or a Crack-up Boom (a race to get out of paper currencies, click here for further reading) we discussed in our SVB Solution Set. Through this New Vol lens, new solutions are needed. But first, let’s set the table.
CURRENT VOLATILITY SOLUTIONS
Options and volatility can be our friend. There is a spectrum to everything, and options can be as risky or as benign as you’d like, from wild speculation to customized solutions. Interestingly, the volatility space as an asset class has been growing as the general markets have struggled. Volatility products have gained assets, which makes sense given that the inflation genie is out of the bottle and the major bullwhip effect from our responses to Covid.
We see new products and solutions with “hedged equity” portfolios and a number of new players and platforms to help navigate through this paradigm shift towards higher volatility. These hedged equity portfolios are traditional portfolios with embedded option positions. That is the good news. The challenge is back to – what are we hedging, why are hedging, and how much does it cost? Remember that equities only made up 20% of our multi-asset portfolio (see post here). We still have a lot of other risks to contend with. For this reason, let’s circle back to the world of insurance.
A simple and powerful insurance concept that resonates with us here at C&P is for investors to insure the small risks and let the insurance company assume the big risks. A practical example of this would be for us (the insured) to choose higher deductibles to get the lower premiums. We can handle the risk of a “small accident” and pay out of pocket if this were to happen. But, if we are in a more serious accident (with injuries and lawsuits), the insurance company has us covered. Now we want to take this same concept and apply it to our portfolios, the markets, and life in general.
THE VIX IS A WINNER BUT NOT A SOLUTION
A favorite market gauge of measuring risk and volatility is the VIX. The VIX index is a real-time market index representing the market’s expectations of future volatility. The VIX index is popular for two main reasons. First, it gauges the level of perceived risk in the “”markets””. Second, because the VIX index is replicable in the listed options market (the VIX is calculated by using a series of listed SPX options – for further explanations of the VIX click here), the options on the VIX index are extremely liquid and active. Because market makers can directly hedge their VIX option exposure through this series of SPX options, the risks are well defined, thus managed. We will not get too far into the mechanics of this index, but it is worth highlighting a couple of concepts. Skip to the next section if your head starts to hurt from this abbreviated VIX lesson.
There are futures and options on the VIX index. On the surface, these VIX products appear to offer solid protection against a portfolio. In our 2022 example and analysis of volatility hedges (see post here), the VIX index was up roughly 26% in 2022. So, in 2022, the market was down and the VIX was up, thus the VIX index did what it was supposed to do – offer protection against a market decline. That is the good news. The challenge is that the VIX is very difficult to “trade”. The VIX is difficult to size, scale, monitor, and monetize against a given portfolio. Let’s look at an example.
Assume the market has a really big down day and the VIX goes from 20 to 40. The VIX is now 40, but because it is widely believed that things will eventually stabilize (mean-reverting tendencies), the VIX options will be priced based on a future VIX price of 35. And if the market does in fact stabilize and the VIX goes back to 35, the options may now be priced off a 30 VIX. If that is not confusing enough, it’s important to note that all of this action can take place over just a couple of trading sessions. So, in this scenario, you can see how difficult it would be to exit/monetize your portfolio hedge with the VIX derivatives (futures and options). Then we get into the concepts of how many VIX options do we need (position sizing), and we should also mention that if the market gets more volatile, these options are more expensive and less liquid.
As you can see, the VIX is very nuanced and technical, which is also why we do not favor this index for any longer-term hedges. The VIX is a great trading vehicle, as it is liquid for shorter-term speculations, but when it comes to portfolio construction, we are leaving the VIX out of the solution set.
NEW DEFINITIONS NEEDED
We are inching our way towards new solutions. We want protection, as we can see and feel the chaos. But the current solutions are more complex then the volatility problem we are trying to solve. We can trade volatility explicitly through the VIX and accept all the nuance. Or we can trade volatility implicitly through these newer products, but the results are unproven, the costs are not clear, and they are not a full portfolio hedge.
This is where we broaden our lens. We need to change definitions. Rather than trying to protect against volatility and the market going lower, let’s look for protection against a shock to the system that causes something bigger than just a market hiccup. We want a hedge against chaos. We are exploring the unknown. We refer back to the Ice-9 and our Crack-up Boom examples as potential outcomes. Ice-9 is a scenario where all the leverage and interconnectedness causes the entire system to seize. And the crack-up boom is a race to convert all fiat/currency, as the currency is rapidly losing purchasing power.
Just like our insurance example, we can view a market correction as the smaller risk, and the bigger and more dangerous risk we need to protect against is a really big down move that may cause a market freeze, or a global currency crisis, or a market shut-down for any/many other reasons.
Again, this is a thought experiment. We are building an awareness to where we are in the story and exploring new ideas. We’ve had this solution the whole time, but in order to implement, we needed to change definitions. We need to adjust our expectations where nothing should surprise. We have set the table for our outside the box idea of building personal resilience. The journey continues.
Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.
