As Baupost’s President and Head of Public Investments Jim Mooney looks at the current volatility landscape, he uses a mathematical logic that considers the mechanics of how leverage impacts the risk management terrain. His logic (and likely that of his famous boss, Seth Klarman) is that statistically abnormal volatility – the CBOE VIX index was knuckle dragging near 9.50 in early Friday trading – leads to higher market leverage that is increasingly common to document as systematic, algorithmically driven strategies dominate markets. It is at this intersection that Mooney – known in part for his skills at finding value after a market disaster as evidenced by purchasing Madoff claims after that complex settlement process – thinks he understands what is likely to be the next “accelerant” to the market crash. Leverage and systematic portfolio adjustments could exacerbate the rush to the exit whenever that seemingly inevitable event occurs, Mooney told investors in a Q2 Baupost Letter reviewed by ValueWalk.
Baupost Letter - With algorithmic programs running markets as never before, this time it really could be different
Unlike the era where human emotions were more materially identified as performance drivers tied to market volatility, the historic implementation of algorithmic thinking into markets exposes a different decision-making process that could impact markets in very different ways. The next time volatility strikes, it could be different, and Mooney points to systematic factors to back up his thesis.
The current bout of low volatility is generally explained by several factors. "The most prominent explanation is that the low realized volatility, which results when asset prices march steadily upward with very few interruptions, naturally causes quantitative models to predict a continuation of subdued volatility, i.e. low implied volatility." The formula leads to a model where low volatility begets lower volatility. The performance driver for these "dampened market fluctuations" is steady buying of stocks resulting from assets flowing into passively managed index funds, Mooney says.
While passive flows into the markets could be one point of causation for the historic market malady that appears to have positive symptoms, the root of the problem is discovered during a market crash.
“Structural leverage linked to low realized volatility may well prove destabilizing and the precipitant, or at least an accelerant, for the next financial crisis,” Mooney wrote in the Q2 Baupost Letter.
He notes that the core mathematical formula behind many of the algorithmically-based risk parity and volatility targeting strategies feature market volatility as a trigger to increase or decrease risk exposure. This impacts markets going up different than when going down.
Unlike those pesky humans, who cannot be definitively relied upon to make the same bad decisions leading up to and during a market crisis, a formula delivers the exact same output given similar input. With a higher percentage of systematic decision making driving markets than at any time in history – some analysts such as JPMorgan’s Marko Kolanovic say only 10% of market trading is human-based fundamental decision making – the impact of systematic programs on the next market crash becomes an exercise in connecting logical dots.
Mooney takes the issue of systematic influences driving markets as never before, puts it into specific terms and points to performance drivers:
Realized volatility is the essential input for Value-at-Risk (VaR) calculations, and determines the degree of leverage incorporated in a variety of quantitative and structured investment strategies. For instance, the models used by both risk parity and volatility targeting funds, which use volatility levels to determine asset allocations, have been signalling “risk-on” for some time. This has resulted in steadily increased portfolio leverage as realized volatility has fallen across asset classes. Additionally, certain structured short-volatility ETFs have algorithm-based selling and buying programs that automatically lever up and, critically, down based on realized volatility.
While these risk parity and volatility targeting systematic programs generally lever up during periods of low volatility and then do the opposite as volatility strikes -- selling during a market crash.
While it might sound bold to predict a major point of causation for the next financial crisis, the conversation regarding systematic passive strategies overwhelming markets isn’t that radical or new and Mooney is connecting quantitative dots. It involves a logical understanding of algorithmic forces driving market prices and it might not paint a pretty picture during the next market crash.
Watch for our next article on the Baupost letter that will discuss performance drivers in more detail.