The only thing to fear is lack of fear

Despite February’s volatility, investors appear relatively unconcerned about market risk. Should we be more worried?

Something scary is bubbling under the surface in financial markets and could blow up into a sub-prime style crisis, leading fund managers have warned. The reason? Investors have become too complacent about macro risks and are behaving as if the era of cheap and easy money will never end.

Early February’s market sell-off caused a short term spike in volatility, triggered by stronger than expected US earnings data which raised concerns about inflation and the timing of interest rate hikes. It was sudden and dramatic, but this market correction was also short lived. Although it wiped out a lot of last year’s gains from record high stock markets, it did not cause contagion across other asset classes or a rush to safe havens.

Volatility began to fall back again quite quickly, suggesting that investor complacency still underpins the markets. Volatility has been so low for so long that many investors now consider it normal, and this could be leading them to take excessive risk. The level of the Vix index, the so-called ‘fear gauge’, hit 37 in February, but has averaged a muted 20 over the long term (see chart). Financial markets have simply not been reacting to macro events which should be market-movers, such as the North Korea nuclear threat, Brexit, or the end of QE.

Kevin Murphy, co-head of Schroders’ Global Value team, says this complacency is what is worrying him most in markets at the moment. Warren Buffett famously said investors should be greedy when others are fearful and fearful when others are greedy, but what happens when no-one is fearful?

‘Everyone else’s complacency is the one thing that really concerns me, and I think it means many people in financial markets are making mistakes,’ says Murphy. ‘This long-term environment of low volatility and low rates means it’s likely someone out there is gearing up very aggressively to try and benefit from something they think is really clever. The problem is, low rates and low volatility are here temporarily. Just as we didn’t know about the sub-prime crisis – it was fuelled by cheap debt and house prices that people thought would always go up – a similar issue could be boiling under the surface in financial markets. That is what we fear the most.’

The problem with low volatility funds

Is there one particular trade in the market that Murphy is thinking of when he talks about investors making mistakes? What stands out for him is the growing number of products specifically offering investors returns with low volatility, including exchange traded funds (ETFs). The number of low-volatility funds in Europe has doubled in the last five years, according to Morningstar, with assets under management at €40 billion at the end of 2016, of which 15 per cent was in ETFs.

Murphy suggests that the popularity of low volatility strategies is one of the reasons why the Vix was so low before the latest sell-off. ‘The thing everyone wants is the thing they shouldn’t have. They want equity-like returns with low volatility. They want to lose weight without exercising. They want to get rich quick.’

Speaking before February’s market falls, he predicted losses for investors in these products: ‘Valuations are unlikely to remain elevated and the Vix is unlikely to remain low, but the combination of the two is often found in these equity-like, low volatility products. If you have one of those factors go wrong on you, you lose a lot of money. If you have both of them go wrong, the losses might be very significant indeed.’

A few weeks later, and those losses materialised. Trading was halted in three US-listed inverse Vix ETFs, which had bet on continued low volatility, after they suffered heavy falls, while other low volatility exchange traded products lost more than 80 per cent in a day.

A long overdue shake-out?

A number of investors had forecast a short-term equity sell-off this year. Research by asset manager Managing Partners Group in January revealed that seven out of 10 institutional investors anticipated a global equity market correction of more than 10 per cent within 18 months, and many had been selling down equities in anticipation.

Neil Woodford of Woodford Investment Management was another prominent investor who warned towards the end of last year that markets could come off the boil. He blamed ‘the biggest monetary policy experiment in history’ for making investors forget about risk, leading to inflated valuations. ‘Whether it’s bitcoin going through $10,000, European junk bonds yielding less than US Treasuries, historic low levels of volatility or smart beta ETFs attracting gigantic inflows – there are so many lights flashing red that I am losing count,’ he said.

Anthony Rayner, fund manager on Miton’s multi-asset team, says measured volatility was low across most asset classes last year; he suspects that low interest rates dampened risk as an environment of cheap borrowing lifted asset prices and masked macro risks. The recent sell-off was a reappraisal by investors of the path of interest rates, he says, as well as an expected ‘shakeout’ in markets. ‘Is the central bank’s hand being forced by higher wages and inflationary pressures? That is what the market is worried about,’ he says.

‘At the moment it feels like market movements are sentiment-driven. But if we do get an extended period of financial market volatility, something which leads to tighter conditions and disruption like we have seen in February, that will start to attack the strong fundamentals we are currently seeing.’

Premier Asset Management’s chief investment officer Neil Birrell had also previously warned that an interest rate or inflation shock could upset the markets. ‘Is this sell-off just a blip? Let’s hope so. The scale of it was not surprising, but the speed was. It was exacerbated by the short volatility trade that was on. The reaction of the markets was, in many ways, quite muted. I predicted an interest rate or inflation shock could be the trigger and that is what happened.’ He adds the bond market took it quite well, with only a modest 0.1 per cent move up in the 10-year US Treasury bond yield.

‘The Bank of England is talking about raising rates as the economy is growing, so the fundamentals are still quite good, but valuations are high and it is unreasonable to expect the returns of 2016-17 to be repeated.’

Bonds are not immune

Fears about investor complacency are present in bond markets, too, over the longer term. Fidelity Investments’ senior fixed income portfolio manager Ian Spreadbury points to underlying structural issues that have led to persistently low economic growth and low inflation. One of these is high levels of corporate and consumer debt, the effect of which has been to make the global economy more sensitive to interest rates. ‘I think it’s a real concern. There is an underlying level of systemic risk that is not being fully recognised by the market.’

The manager notes that historically low volatility can exacerbate the problem in the event of a sudden spike, as it shocks those investors who have never known anything else.

Protecting portfolios

Spreadbury’s strategy has been to put a large chunk of the Fidelity Strategic Bond fund he manages into core high-conviction credits which can survive in the event of downside risk.

Multi-asset fund manager Rayner, meanwhile, is defensively positioned in bonds, holding those at the top end of the quality spectrum and keeping his interest rate risk low by holding short-duration bonds which are less sensitive to rate changes. But he says investors need to move beyond the idea that bonds guarantee protection when stock markets fall. He notes that a 10-year US Treasury bill was yielding 2 per cent in September but is now yielding 2.8 per cent (as at start of February), meaning investors would have suffered a capital loss in that time on a supposed ‘risk-free asset’. ‘I think those investors with these hard-based risk models that say “bonds always protect you if equities fall” need to look beyond that,’ he says.

On the equity side, Rayner has kept last year’s exposure to economically sensitive sectors like miners, oils, industrials and banks, but he has also been rotating out of expensive positions and adding to inflation beneficiaries. He also has some gold in the more defensive Miton funds as an inflation hedge and as a potential stand-in for bonds. He suggests investors should keep portfolios liquid but not hold too much cash,and remain vigilant and ready to change direction quickly.

At Premier, Birrell has been paring back equity exposure in his Diversified funds for a while,and has also bought put options on the S&P 500. This buys him the right to sell stocks at a pre-agreed price, so he can still make money if the market falls below its current record level. These options paid off for him during the recent correction.

As for Murphy, he is hoping a focus on cash-rich companies and good diversification will help him navigate the unknowns ahead. ‘If you knew the future, what would you do? You’d build a very concentrated portfolio and you would lever it up very significantly. But if you don’t know the future, then the opposite must be true. That means diversify and only use a very small amount of leverage, if any. We’re looking for companies where the balance sheets are strong, just in case. That’s our only insurance policy.’ 

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