Being bearish on the market can be extremely expensive over time
by Axel MerkMr. Merk is President and Chief Investment Officer, Merk Investments, and manager of the Merk Funds. Reprinted with permission. Connect with him by e-mail.
By definition, Black Swans in financial markets are rare, extreme events. How do you survive, possibly even thrive when the unthinkable happens? Let’s evaluate the pros and cons of some Black Swan mitigation strategies: Nassim Taleb’s best-selling “Black Swan” author has in the past suggested that he’s constantly taking small losses in hopes of a big payoff some-day.
The Pro: if the payoff comes, you have bragging rights;
The Cons: as the ten+ year bull market preceding the market panic this year has shown, being bearish on the market can be extremely expensive over time. Many have had to throw in the towel on so-called negative carry strategies (strategies that cost a little bit as time moves on, in hope of larger gains down the road). The other big challenge with any bet against “the market” is that we don’t necessarily know which market will provide a large payoff in a decline. It’s easily said to have a bearish bet, but when it comes to implementing it, one has to choose a specific instrument; no one guarantees that this specific instrument will actually perform as intended when the time comes. The dislocations in March suggest that a lot of instruments “misbehaved.”
This doesn’t mean taking positions on bad outcomes is a loser’s game. When markets price in a goldilocks economy, there may well be certain types of insurance that are attractively priced. Incidentally, I notice that we have not removed a reference to a “lower rates strategy” from our website, where we offered to implement just that for those who would listen; alas, few act when the price is right, and right now, rates can’t go much lower, so no, the price is not right.
An anecdote illustrates the tough choices: Calpers, the California pension fund with over $370 billion in assets according to Blomberg was in the news for having sold out of a hedge fund Mr. Taleb is affiliated with before the market rout. Calpers CIO Ben Meng, who used to teach risk management classes, defended the choice on a webcast: ”We chose better alternatives for market drawdown protection and they turned out to be better alternatives in the recent market rout.” Mr. Taleb, in turn did what he appears to be best at: he suggested he, not others, understand statistics. (Source: Bloomberg 4/17/2020 coverage).
Ultimately, if you don’t want to be wiped out by a Black Swan event, avoid using leverage and only invest in assets that are positive carry, long-duration assets. At least you can “only” lose 100% that way. Odds are, though, that if you have a diversified equity portfolio, not everything will go to zero. Notice that disclaimer: “odds are”?!
As I’m writing this, the May contract for WTI oil is trading at minus $40. Oil may have been around for thousands of years, but anyone buying oil usually buys a contract with specific terms. And if you bought oil for May delivery in Cushing, the commonly cited WTI Crude contract, you would have to pay for storage until you pick it up, hence you’re willing to pay only a negative amount to actually accept the oil (before storage cost). A common trade to “roll” the contract to a forward maturity costs an arm and a leg as the forward prices are substantially higher; that is, it is not a “positive carry” trade. We are not advocating the trading of derivatives, only highlight what some may call a Black Swan event – certainly a historically unprecedented one – in the oil market.
If there are true arbitrage opportunities, you may want to sidestep other sort of investments and simply focus on those. The small print is important, though, as perceived arbitrage opportunities are often there for a good reason.
As an example, there are mundane ones, such as the breakdown of interest rate parity. Theoretically, it should be equivalent to buying a foreign currency, hold the cash (earning interest); versus buying forward contract and earning interest domestically. Except that since Dodd-Frank and equivalent regulations around the world have passed, these arbitrage opportunities have not been taken off the table. This may quite possibly be because those with the balance sheets to do so are prevented by regulation these days. And for others, they don’t have low enough borrowing costs to make it profitable; and to pursue it without leverage would tie up a lot of capital given miniscule profit potential. And let’s not forget that a forward currency contract contains counter-party risk; as such, the arbitrage opportunity does have some small-print risk (which only matter if there were, well, a Black Swan).
There’s a breed of financial players that thrive on financial arbitrage. Take the market makers that make a market in your favorite exchange traded products. While exchange rules are stacked in the market makers’ favor,1 many market makers don’t seek to make an almost guaranteed profit on each transaction, but only on average. That is, they make a tighter market than their competitors and make it up through a large volume of transactions that are, on average, profitable.
This sort of arbitrage is an extremely competitive space (think high frequency traders) requiring substantial technology investment that most mortals cannot participate in.
There’s a lot to be learned from these players, though:
- The ability of a market maker to make a market is as good as the market maker’s ability to hedge its position. You may have noticed that for ETFs that trade with a very tight spread that are sensitive to economic data, spreads tend to widen just ahead of major economic releases. This is risk management of the market makers at work. Their own hedging cost goes up and they pass that cost along. The lesson here is that we may be better off if we know the risks associated with anything we do, and adjust as the environment changes. More on that in a moment.
- During the extreme days in March, it’s our best assessment that some of those market makers reached their limits. No, they didn’t falter, but they stopped making a tight market. They took a step back. Market makers in ETFs can usually offload their risk at the end of the day (through the share creation/redemption process); usually, they have plenty of buffer, but when caught in an extreme environment, they opted to preserve their business by ceding to make a market. Investors may be left holding the bag with wider spreads, but market makers did what was necessary to preserve the integrity of the system. The lesson for us non-market-makers is to know our risk limit and have a plan when we reach it. The latter is crucial, as you don’t want to be caught in a situation where you scramble to come up with a plan with your back against the wall.
- When you have a market panic, market makers at times cannot internalize flow (just crossing orders for spread), they have to openly trade with other market makers to sell them their risk to, and in times of market turmoil it almost becomes like an adverse-selection scenario, where nobody wants to trade with another because they fear they don’t have the same information. That seemed to have happened to some markets resulting in very poor market depth; major currencies that on a “normal” day move less than a percent moved more than 10 percent in a few minutes.
Whereas market makers are risk managers, statistical arbitrageurs are risk takers. Statistical arbitrage thrives when things are temporarily out-of-whack (i.e. correlations) and you bet on them converging to their statistical long-term mean. For the most part, it’s our understanding that those strategies were the ones getting hit the hardest because markets kept cascading in the same direction rather than normalizing. Instead, momentum-based strategies did very well. A large hedge fund was in the news for excellent Q1 performance, but whereas the media attributed gains to statistical arbitrage, we believe it was probably more likely to be pure arbitrage based on having an edge on faster information (high-frequency trading based on different pricing on different venues).
When it comes to plan for the next Black Swans, you almost certainly are fighting the last war. Did you think a global pandemic would derail markets, and did you have any idea how it would / will play out? You can look for warning signs, but I caution that you want to be humble enough to recognize that you may be looking in the wrong places. With that caveat out of the way, here are a few examples of risk parameters to look out for. In the example below, I focus on the currency markets, but similar monitors can be built for other markets:
- Spreads. Spreads in the currency markets are miniscule during normal times, but even there, certain times (8am ET through 3pm ET) are considered most liquid. “Normal” spreads are in the eyes of the beholder and may well require a human element; we shouldn’t be lured into a new normal simply because spreads have been elevated for a few weeks.
- Implied volatility. For a primer on implied volatility, see investopedia. I’m not about to encourage you to trade options, but studying the options market allows us to get an immediate read as to what those writing the options are charging. Think of it as you buying insurance; when there’s a fire, getting fire insurance is more expensive. Similarly, you can gauge what it costs to insure yourself in the options market. You can look at the cost relative to a moving average to gauge whether costs are increasing. Note that “insurance cost” naturally increases ahead of known events (think major elections, Brexit vote). Just as with insurance, implied volatility can be looked at over different horizons. One-week implied volatility is going to be much more fickle than one-month implied volatility; Looking at how the market is pricing risk is helpful in assessing an event, or picking up on risks not associated with a well defined event.
Aside from looking at market-based risks, it may be prudent to look at risks in one’s portfolio. This is a broader discussion for another day; just note that many models are based on normal distributions, and that in a market rout, distributions are anything but normal. Any monitoring (and risk forecasting) tool must be sufficiently humble to take into account the limitations of the assumptions put into it.
There’s no silver bullet to manage Black Swans, otherwise they wouldn’t be called Black Swans. That said:
Just as you do fire and earthquake drills to be better prepared when disaster strikes, you may be better equipped to deal with the next Black Swan when you monitor portfolio risk and have a plan. The plan is crucial, as when the earthquake hits, you need to act fast; sure, you will adjust your action based on the reality that moment, but at least you’ve thought about the options beforehand. Similarly, consider having a plan for your investment portfolio. When events and news are most irritating, it may be helpful to take a deep breath and think about your options. A deep breath, yes, but you may not have the time to convene committees or ponder too long about what action to take.
But make no mistake about it: good risk management may well mean leaving upside return on the table.
Reach out to us if you want to see whether we can help you manage risk. Please sign up for our free Merk Insights, explore our chartbooks and follow me on LinkedIn, Twitter or Facebook.
1. Market makers receive a “rebate” on shares in which they make a market, often only a fraction of a cent; it provides market makers an incentive to keep spreads tight. The exchange takes this rebate from non-market maker transaction fees, or from fees paid by the sponsor of the security.
Subscribe To Merk Insights Share
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Merk Investments LLC makes no representation regarding the advisability of investing in the products herein. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice and is not intended as an endorsement of any specific investment. The information contained herein is general in nature and is provided solely for educational and informational purposes. The information provided does not constitute legal, financial or tax advice. You should obtain advice specific to your circumstances from your own legal, financial and tax advisors. Past performance is no guarantee of future results.