Why it is still better to be lucky than smart.
As you purvey the current carnage in the financial markets, it’s difficult not to get despondent. It is in times like these that we turn to music to help us lift our spirits, or wallow in self-pity. I can recommend the most depressing song in the world, aptly called The End by the Doors, which has helped me get over much teenage angst and romance gone wrong. I suppose the point at which most of us lost all hope during this virus induced crisis, was when we realised that we could not buy any more toilet paper. But of course worse was yet to come, and as we try to home school our kids, work remotely, and are forbidden from leaving our dwellings the reality has finally set in: This is the end, beautiful friend, this is the end, my only friend.
I imagine quite a few investment managers who rely on correlation to manage their portfolios are listening to this song these days. Cash is cheap and if you found a way to make money, why not try to make more money? That’s where leverage comes in and it usually comes as part of the perceived risk of whatever it is that you are doing. The way risk is measured in the financial world is by assessing how much a particular investment will move up and down. If something moves more than 10% per day, you will find far less suiters to provide you a line of credit than for something that goes up and down by only 1% per day. Elementary you say? Absolutely, but here is where financial engineering comes in. To bring down the risk so you can borrow more, all you have to do is buy (or sell) something else that will reduce the overall volatility of your investment strategy. The classic example is to buy stocks and bonds, because wait for it, they are usually negatively correlated. So, if one goes down, the other goes up.
But of course, many think they are much smarter than that, and they can find a multitude of things that they can package, so that their overall value at risk is even lower. How about some gold or platinum, that will surely reduce the risk? Absolutely. Bitcoin? That stuff isn’t correlated to anything, so let’s throw that in there as well. Commodities, single stocks, sector ETFs, country indices, govvies, corporate bonds, high yield debt, long, short, cross marginalised, optimised, curve fitted with some algos and mathematics thrown in that no-one will understand? Go for it. It’s worked in the past, so surely it must work forever and clearly the numbers don’t lie. So, lend the banks did, leverage is king, cash is dead, and we all lived happily ever after.
And then came the bill. The first thing that happens in a crash, is that correlations go to one. That means that everything goes down, even those so called “safe haven” assets like gold, government or investment grade bonds. The other thing that happens is that volatility goes up. With the VIX (measure of volatility on the S&P 500) going from 10 in January to 100 in March, you could crudely estimate that the risk of any leveraged portfolio increased by a factor of 10. What happens, when the banks realise this? They call for more collateral from the borrower to protect against the potential losses. The problem is that the portfolio is haemorrhaging money, just when you need to cough up more cash to the bank. The whole thing results in one certainty: forced selling. So, if you were wondering why everything but the kitchen sink was thrown into the market at any price this month, well you can stop trying to make sense of it all. Have I mentioned that it might help listening to some nice depressing music while you wait for the dust to settle?