The managers of the Ruffer Investment Company are concerned the industry's obsession with low volatility could lead to the next financial crisis.
The seeds of the next financial crisis are likely to lie within the fund management industry rather than the banking system, according to the managers of Ruffer Investment Company (RICA).
Managers Hamish Baillie, Steve Russell and Duncan MacInnes have significant concerns about the way that stock market volatility is viewed and used by investors.
‘Volatility is an obscure financial metric, having morphed from an observed output and barometer of financial stress, into a widely used input for many investment strategies,’ they explained in Ruffer’s January update.
They believe the words of economist Charles Goodhart are particularly pertinent to today’s environment: namely, ‘when a measure becomes a target, it ceases to be a good measure’.
Here, they are referring to the broad swathe of funds that target low volatility. With an estimated $1 trillion of assets in these funds, they believe too much money is at risk in the event of a spike in market volatility.
‘This self-feeding mechanism is inherently unstable and if events cause a reversal (ie, a spike in volatility) the result could be a sharp sell-off in asset markets. This process is exacerbated by the rise of computer-driven trading models and passive investment, both of which are strictly rule-based and unthinking in execution,’ the managers explained.
With this in mind, they concluded that the seeds of the next financial crisis could lie with the fund management industry, rather than the banking system.
Short volatility strategies hit
The fund managers’ comments will certainly strike a chord with investors following the events of last week. Markets started the year by hitting all-time highs, but stuttered in recent weeks. The sell-off then accelerated dramatically after unexpectedly strong US wage inflation data raised fears of the Federal Reserve ushering in a more rapid series of interest rate rises that would definitively bring down the curtain on the post-financial crisis era of easy money.
As a result, the VIX index (which measures volatility) spiked and the Dow Jones officially entered 'correction' territory, having fallen by more than 10% from its peak.
Stock market turbulence hit volatility exchange-traded notes (ETNs) and ETFs. These products allow investors to profit when volatility is low. However, they experienced significant falls after volatility rose this week.
Assets in Credit Suisse’s VelocityShares Daily Inverse VIX Short-Term ETN (XIV) had topped $2 billion in late January, but by the close of Wednesday, they had fallen to $79.7 million. This was caused by the US market experiencing its worst fall on Monday for more than six years. Year-to-date, Credit Suisse's product is down 94.5%, which caused the bank to begin an early redemption. ETNs are a type of unsecured, unsubordinated debt security that are issued by an underwriting bank.
Other short volatility products experienced significant losses. For example, the ProShares Short VIX Short-Term Futures ETF is down 90.5% year-to-date.
Like Credit Suisse, Japanese bank Nomura has also announced plans to close its Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN following a sharp fall in value.
Search for safe havens
The Ruffer managers pointed out that the health of the bond market is the main difference between today’s market conditions and those of the 2008 credit crunch. After nine years of central bank bond buying activity, known as quantitative easing, bond markets have been distorted. Historic correlations have broken down, which means that bonds no longer fulfil their conventional role as safe haven assets during times of market stress.
‘Despite their uncomfortable cost of carry, we believe our options and illiquid strategies to be absolutely essential,’ the trio concluded.
Japanese equities currently represent the biggest allocation in Ruffer's multi-asset portfolio at 19%, followed by cash and non-UK index-linked bonds at 14% apiece.
Ruffer's share price has risen by 19.9% over the past five years. This compares to a 53% gain by the average fund in the Association of Investment Companies’ flexible investment sector. The fund currently trades on a 3.3% premium to net asset value, which compares to an average discount of 7%.