Low Volatility and The Danger of Increased Leverage

After a sharp move in the VIX a week ago, today the volatility index finished below 10 (9.99 to be exact). It looks like we are going into a low-volatility period again.

Last week, just before the volatility spike, Mohamed A. El-Erian warned of the danger of investing in a low-volatility environment. He said that low volatility encourages excessive risk taking.

The smoother the road, the faster people are likely to drive. The faster they drive, the more excited they are about getting to their destination in good, if not record time; but, also, the greater the risk of an accident that could also harm other drivers, including those driving slower and more carefully.

The lower the market volatility, the less likely a trader is to be “stopped out” of a position by short-term price fluctuations. Under such circumstances, traders are enticed to put on bigger positions and assume greater risks.

But why do traders take more risks when volatility is low? According to El-Erian, asset allocation and portfolio optimization models allocate more funds to assets that have lower volatilities.

Expected volatility is among the three major inputs that drive asset-allocation models, including the “policy portfolio” optimization approach used by quite a few foundations and endowments (the other two variables being expected returns and expected correlation). As the specifications of such expectations are often overly influenced by observations from recent history, the lower the volatility of an asset class, the more the optimizer will allocate funds to it. Read more

Similarly, Man Group Chief Investment Officer Sandy Rattray said

One concern is that many people choose to scale their positions by the level of realized volatility, which means there could be very large positions out there today with potentially significant leverage that might be vulnerable should volatility rise whether due to a tail risk event or other developments in the market,” raising an issue that analysts such as JPMorgan’s Marko Kolanovic and others have pointed out. Read more

He was referring to the risk parity model that also allocates more funds to assets that have lower volatilities, thus increasing the size of the positions.

In the equity market-neutral world, funds are also increasing size through leverage. The explanation is, however, different. In time of low volatility, equity market neutral funds suffer due the muted asset movement, and in order to maintain the returns they need to increase the leverage. Indeed Dani Burger of Bloomberg reported:

The pain of an almost paralyzed stock market has seeped its way into the money machine of equity quants, raising anxiety levels among analysts who say they’ve seen this movie before.

“If you’re in a long-in-the-tooth factor that everyone is involved in, that’s going down in volatility, one way to offset the reduced returns is with leverage,” said Mark Connors, the global head of risk advisory at Credit Suisse Group AG. “For any event, whether it’s a blip or a big macro event, there’s then a greater chance of sharp deleveraging.” Read more

Regardless of the reason for an increase in position size and/or leverage, a sound risk management plan is critical, as emphasized by Man Group CIO:

…investors need to have a plan to manage risk, not just focus on stock market reward.

That plan could potentially involve a hedging strategy, a fund-management strategy, or it could come down to asset allocation or rebalancing—though rebalancing, of course, may exacerbate drawdowns

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