Recent Volatility Reveals Vulnerability In Unbalanced Portfolios

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It’s been a few weeks since the volatility blow up in February sent stocks lower, and many investors may still be scared or scratching their heads as to what caused the correction. Now that the dust seems to have settled, we thought it was a good time to provide Longboard’s view on those events, and the impact they could have going forward.

Check out our H2 hedge fund letters here.

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The real danger of volatility

On Friday February 2, employment data indicated higher wage inflation. Inflation was notably elusive during the global recovery, and some investors started to get concerned that the U.S. Federal Reserve would tighten interest rates faster than planned. On February 5, stocks started to look shaky and volatility (as measured by the CBOE Volatility Index, or VIX) began to rise. By the next day, volatility had spiked and stocks were not looking good.

At one point on Monday February 6, the VIX spiked to levels that historically have come before a -20% stock correction. We interpreted this “volatility overshoot” as the canary in the coal mine. There were concerns about high equity valuations and contained volatility. Yet it seemed to us that the subdued equity volatility was most vulnerable. Volatility is particularly dangerous because it is an input to many trading strategies, including options and credit trading.

Technical vs. fundamental sell-off

During the global financial crisis, we saw credit tighten followed by stocks crashing. Then equity volatility spiked. In early February, we saw this pattern in reverse. Equity volatility spiked, followed by stocks suffering. Yet, credit remained functional, market liquidity remained reasonable and funding was available.

Our view at the time was that, although things weren’t pretty, they weren’t scary either. The episodic equity sell-off in February is now behind us and March seems to be bringing its own set of challenges.  Much remains to be seen in terms of the future path of the stock market but the tone of market participants is different.

Goldman Sachs pointed out that stocks held by hedge funds outperformed. That indicates this was a technical sell-off, instead of a fundamental one. What’s more, many technical traders believe this type of price action can be healthy for stocks in the long run. Even if stocks are technically healthier, we’re hearing more conversations about the next leg lower and a real recession.

So, why did some funds close and some funds outperform?

As is often the case, it comes down to a commitment to robust risk management. When macro themes persist for a long period of time – for example, the persistent subdued volatility theme we saw during the global financial recovery – they have a tendency to seep into a variety of areas.

Without the experience of changing macro themes and the awareness that markets can change on a dime, risk can become concentrated and portfolios can become vulnerable. The assumption that volatility would never spike proved catastrophic for anyone who allowed hopes for a higher return to supersede realistic risk management.  Said another way, defense wins championships.

The benefits of rule-based investing

Investors were aware that historically low volatility would not continue forever. They had voiced concerns over historically high equity valuations for months. After all, we are currently in the third-longest expansionary cycle in U.S. history (105 months). February just reminded us how vulnerable an oversubscribed stock market is.

The good news is that rules-based investing helps keep investors unemotional when others panic. This approach stays committed to preserving and growing wealth, while utilizing dynamic, risk management processes. Best of all, trend following strategies offer the potential for positive returns in both bull and bear cycles.

So, let the wind of change come or not. We believe we’re more than ready for it either way.

Article by Sarah Baldwin, Longboard Funds

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