Donald Rumsfeld’s phrase has joined the group of terms synonymous with risk. When he said this in 2003 he was not talking about financial markets, however financial markets have adopted it. Today there are many known (but not widely known) risks in the derivative instruments we trade. On their own they are not a problem, but when they are used by investors that don’t necessarily understand their idiosyncrasies, combine them in sub-optimal ways, or fail to understand how they are used by the broader market, they can become dangerous.
Today smart beta and risk premia investments satisfy a range of investor needs, and are rightly becoming popular primarily due to their low cost and ability to invest in complex payoffs. Derivatives can be fantastic hedging instruments, but can also be poor for the market when managed poorly. The same can be said for leverage.
Warren Buffett called derivatives "financial weapons of mass destruction" (also in 2003). Derivatives are convex instruments. Their pay-off, based on another asset’s price, moves along a curve (at least prior to expiry). For that reason, this payoff moves more quickly than mere leverage. For example, in a double short S&P ETF, you’ll lose 2% for every 1% the SPX moves up. This is less dangerous than a double short VIX (Volatility Index) ETN (Exchange - Traded Note) – when the VIX short goes bad, the PnL will far outweigh the linear ETF. This is because the VIX ETN of course has a high and non-linear beta to the SPX.
So Buffett is not wrong. There is a clear distinction between linear and convex instruments in terms of their outcome on your portfolio when markets move aggressively to risk off. To that end, being long rather than short convexity can be the difference between protecting your capital and blowing your toes off.
There are many pockets of investment strategies that show characteristics of negative convexity. The amount of money tracking these strategies is increasing thanks largely to the ease of accessing them. Risk premia pick up (selling volatility), volatility targeting, and risk parity are a few examples. This is because generally they de-risk as markets fall and or volatility rises.
Retail is able to access volatility instruments with ease and the outstanding positions continue to increase.
The professional market is happy to allocate to these and other risk premia pick-up strategies given realised volatility has been low for a long time. Volatility today is very low.
I am happy to agree that over the longer term having short volatility strategies in your book can add alpha but, if you are sensitive to path-dependency, there can be some particularly nasty experiences along the way.
All this is fine if you are adding a small piece of carry to your portfolio when allocated in the correct size, and by the investor that has a balanced and well managed portfolio that can handle the negative convexity in them. But I worry, given the size we can now see in this space, that it will flow over into general risk markets. A lot of short convexity strategies are systematic and share similar portfolio construction rules. Their signals can fire at the same time with the risk of a nasty feedback loop.
If this happens, are pension portfolios that have nothing to do with this space at risk because of the effect these strategies may have in a sell off?
Smart beta and risk premia strategies are fine, as long as they are managed properly and owned by people who truly understand them. Some investors in short convexity instruments may not.
Disclaimer: Please note that these are the views of the writer and not necessarily the views of Perennial.
Dan is a Portfolio Manager. He joined Perennial Value in August 2012 after 15 years at UBS Investment Bank where he held the position of Managing Director - Head UBS Fundamental Investment Group. In this role, Dan managed a seven person team...
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