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We believe that a volatility shock will generate a feedback loop that will force equity prices lower. High leverage tied to volatility targeted risk management will mean that any increase in volatility will lead to portfolio rebalancing and position cutting. This negatively correlated leverage effect between equity returns and change in the VIX is real, as measured by researchers at the New York Fed, see “The Low Volatility Puzzle: Are Investors Complacent?”.

Investors have shifted their focus to alternative risk premiums as a method for defining and allocating risk within a portfolio. The alternative risk premium framework can be employed in all asset classes but is especially useful in commodities given the large dispersion in markets and structural features that lend themselves to time varying risk premiums.

Investors should have a growing concern with the reach for yield in the current market. The reach for yield has pushed investors into illiquid issues where the risk profile has changed from credit/carry to credit/carry/illiqudity. Investors will generally receive a higher premium if an asset is illiquid. Unfortunately, illiquidity premiums are hard to measure; consequently, the traditional credit betas will not be properly measured and there could be the mistaken view that there is greater alpha from managers who hold these types of assets.

The latest performance numbers for Ivy League endowments have been nicely displayed in the chart below along with the 60/40 stock/bond portfolio. Since the development of the “endowment” model associated with Yale and the attention on Harvard, the largest endowment, there has been an unusual focus on these funds. There is a fair amount of dispersion between the best and worst managers in the group.

Implied volatility is usually higher than realized volatility so there is a positive volatility risk premium, except when there is a crisis or volatility spike at which time the volatility premium turns negative. A recent CBOE seminar presented a chart on the volatility premium to illustrate the risk.

Investors should be concerned about the unintended behavior from low volatility. Low volatility will lead to higher volatility in the future when investors become complacent about risk, the “Volatility Paradox”. This paradox has been discussed by Richard Bookstaber as early as 2011 and recently referred to in a post on his blog, Our low risk (low volatility) world.

Dan Fuss, the Loomis Sayles bond guru, has been working in fixed income for decades. He has developed a set of four “P’s” with central bank behavior for looking at the macro fixed income environment and his read is suggesting that caution should be applied to any forecast that believes bonds are safe.

And not only the pride of intellect, but the stupidity of intellect. And, above all, the dishonesty, yes, the dishonesty of intellect. Yes, indeed, the dishonesty and trickery of intellect.
-Leo Tolstoy

The spider chart is an alternative way of displaying data that may be useful at showing the strong diversification benefits versus different asset classes and alternatives. Correlations are looked at through a matrix form but the spider or radar graph may better display the most relevant information. Each node on the web may represent a different asset class and show the correlation of each to a single strategy.

Unlike earlier financial disasters, this one will emerge not because of too much speculation, but because of the inverse – too much hedging.
-William Silber on stock market in August 1987

Could this be the problem we are facing with the next financial crisis? There has a significant amount of talk about over-valuation in equities and the reach for yield in fixed income, but there has been less focus on how a financial crisis will evolve. It may not be from speculators changing their views on the market although this could be a catalyst. Selling could be driven by investors who are trying to hedge or mitigate their risk exposures.

From the Minneapolis Fed we have market-based probabilities of a large up or down market move embedded in 12-month options. This is a good market-based view of a large up or down stock market move.

The behavioral finance revolution has been well noted by both academics and practitioners. Multiple Nobel Prizes have gone to economists who have studied in this area, yet investment decision-makers still make the same behavioral mistakes. We have noted our biases but often we have not changed our behavior. Perhaps it is too ingrained, but good has to be reinforced.