Quarterly Market Outlook & Strategy Letter

A Primer on Volatility

Second Quarter of 2017

Jeff Egizi

July 2017

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Executive Summary

The second quarter was marked by divergent performance across the major asset

classes. The strong performance in global equity markets belied a deceleration in key

economic indicators in China and the US, while interest rates and commodity prices fell

in sympathy with the loss in economic momentum.

The Fed continued to withdraw liquidity gradually, bringing the target Fed Funds Rate

range to 1-1.25% while laying out a plan to slowly reduce its balance sheet. The yield

curve flattened as 2-year rates moved higher and 10-year yields fell. Global equities took

these developments in stride, with emerging markets finishing as the top performer in

the first half of the year. Both implied and realized equity volatility ended the quarter

near historic lows.

Extremely low volatility is inconsistent with the ongoing fragility of the global economy

and financial system. The root cause of this divergence is persistent government

intervention in financial markets. The resulting decline in volatility is being reinforced

and amplified by investors’ response to the “central bank put” – even as monetary

authorities are shifting to a tightening bias.

George Soros’s concept of “reflexivity” in financial markets is useful in understanding the

feedback loop between quantitative mandates, such as “risk-parity” funds, and market

volatility. We think that the growth in the quant space is a major factor pushing volatility

far below fair value.

Throughout financial history, reflexive processes have driven markets away from

fundamentals, only to reverse when the gap between market expectations and reality

becomes too wide to sustain itself. The resolution of the current “bubble” in volatility

will be no different, although timing the reversal may be tricky.

Therefore, we continue to implement a “barbell” strategy: underweight US equity and

interest rate risk, overweight relatively attractive international equities, low

duration/floating rate bonds, and cash. We are also considering derivative strategies to

enhance returns (via covered equity market calls) and hedge portfolios against a spike in

volatility (via a long volatility overlay investment).

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The Second Quarter: A Tale of Three Markets

The second quarter and year-to-date have produced divergent signals from the major asset

classes. Global equity markets continued to make new highs, whereas interest rates and

commodities sank. The former conveys optimism on the prospects for growth and corporate

earnings, while the latter suggests worries about softening global activity and inflation

expectations.1

In many ways, recent trends have reestablished a market playbook that characterized much of

the current market cycle. As the economic data in China and the US softened and oil production

ballooned in Q2, investment strategies that benefit from deflation, such as buying bonds and

selling commodities, came back en vogue.

Meanwhile, US equities benefitted from strong momentum in “growth” securities, as is evident

in the outperformance of the “FAANG” stocks.2 Many software- and data-reliant companies are

stealing market share with disruptive new technologies and business models, insulating them

from the weakness in consumer spending. However, equity market breadth has been worsening

as the rally becomes more concentrated in these stocks.

Finally, the Federal Reserve continued to raise interest rates in Q2 and laid out a plan to allow

the Treasury and mortgage securities it bought from 2009 – 2014 to gradually mature, which will

shrink the Fed’s balance sheet over time. Despite the prospect of less government bond buying,

long-term interest rates fell, leading to a flattening of the yield curve. Though a flattening yield

1 Unless otherwise noted, all charts are created by KPF Global using Bloomberg and/or Microsoft Excel.

2 Facebook, Apple, Amazon, Netflix, Google (Alphabet)

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curve often conveys lower future growth expectations, riskier international equity markets were

able to shrug off these developments. Emerging market equities have been one of the

strongest performers year-to-date.

Discerning which asset classes are sending the “right” signals for the medium-term economic

outlook is an open question. However, there is one “asset” that is clearly mispriced relative to

almost any future scenario for the global economy and financial sector: market volatility.

Special Topic: The Volatility Vortex

Current historically-low levels of equity market volatility (both implied and realized) are

inconsistent with global policy uncertainty and weak economic fundamentals, and are

unsustainable.3 Volatility has been driven to these low levels by a self-reinforcing, but incorrect,

perception of stability in the global economy.

The root of this perception is persistent government intervention in financial markets, which

created a mirage that monetary/fiscal policy will always be sufficient to stem (or prevent) bear

markets. This insulated investors against market risk and seemingly reduced uncertainty,

leading to lower variability (volatility) in market returns.

Encouraged by this apparently benign market backdrop, investors pursued short-volatility

strategies such as option writing, direct bets on falling implied volatility, and broad-based

buying of risky assets (usually in passive form). “Risk targeting” strategies, which mechanically

increase portfolio exposure as market volatility falls, also grew during this period. These factors

preserved and magnified the downtrend in volatility.

Now, central banks are beginning to withdraw the liquidity that kick-started the trend, leaving

these crowded trades more exposed to price shocks. Lower equity trading volumes, a

consequence of the growth of passive and quantitative investing, could exacerbate a trend

reversal. Assets that have benefitted disproportionately from falling volatility, such as

overpriced US stocks and bonds, are most at risk. In the following commentary, we explore

these issues in further detail.

3 For example, we discussed the US economy’s severe structural challenges at length in our Q1 2016 Quarterly

Letter.

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Volatility (the annualized standard deviation of market returns) measures the magnitude of asset

price fluctuations, and is commonly used by investors to estimate the “riskiness” of a particular

investment. Most investors prefer the reliability of a steady stream of returns over a wildly

fluctuating price, even if they end up in the same place. As we have discussed in prior letters,

the negative consequences of volatility are not only a matter of perception; long-term

compound returns are lower for investments that exhibit higher volatility, all else being equal.4

Realized volatility refers to the actual historical price fluctuations of an asset. It is the measure

we report to clients and use to calculate the “risk-adjusted” performance of their portfolios.

The VIX index is a measure of implied volatility, or the future equity volatility implied by equity

option prices. The most common use of options, in this example a “put” option, is to pay a small

“premium” that gives one the option to sell equity securities at a predetermined price

(presumably above whatever the market price is at the expiration of the option) and thus to

protect a portfolio against the risk of a large decline in value. It is analogous to insurance. The

price one pays for this insurance is dictated by market participants’ perceived likelihood of a

major market event – the higher the perceived potential for a large fluctuation, the more an

insurance policy against a large market decline should be worth. This “perceived potential for a

large fluctuation” is what the VIX index captures for the S&P 500 Index. It is calculated using

prices of 30-day S&P 500 options.

As the following chart shows, the VIX Index and realized S&P 500 volatility have been declining

steadily since the Great Financial Crisis, with the periodic spikes in volatility (tending to coincide

with equity market corrections) becoming progressively less severe and enduring. VIX hit 9.8%

in early June, which is in the bottom 1% of all observations since the index was launched in the

early 1990s, versus a historical average of 19.5%. The VIX is tracking the realized (actual)

volatility of the market, which ended the quarter at 6.7%. That’s in the bottom 4% of all

observations since 1990, as compared to a historical average of 15.4%.

4 This is known as volatility drag, which we discuss at length in our Q4 2013 Quarterly Letter.

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We think the root cause of suppressed volatility is increased government involvement in

financial markets. The “Greenspan put” has been around for nearly two decades, and has since

intensified into the Bernanke/Yellen/Draghi/Kuroda put, becoming progressively entrenched in

global investor expectations. The phrase originated with former Fed Chairman Alan Greenspan’s

support of US markets during the Long-Term Capital Management crisis in 1998, and refers to

the widespread belief that central bankers will use monetary policy (by dropping interest rates

and increasing the money supply5) to curtail major downturns in the equity market.

This behavior isn’t confined to central banks. With Keynesianism run amok, governments

around the world have sought to mitigate any economic and/or financial weakness. The US

Treasury’s direct purchase of bad assets from US banks in 2008 (Troubled Asset Relief Program),

the 2010 creation of a centralized fiscal entity in Europe in response to the Eurozone sovereign

crisis (European Financial Stability Facility), and China’s periodic ramp-ups in infrastructure

spending in response to signs of economic slowdown are all recent examples of governments

preventing capital markets from “clearing the deck” after excessive bad debts build in the

system.

The real issue is the moral hazard in investment decisions that these interventions create. The

use of the term “put” in the phrase “Greenspan put” is apt: why spend money on market

insurance when the Central Bank and Treasury already have your back? All else equal, the

market price of insurance should decline in such an environment.

5 Reducing interest rates lowers the corporate cost of capital and the discount rate applied to expected corporate

cash flows, supporting equity prices. Increasing the money supply (printing money) is used as a tool to reduce

interest rates and boost market liquidity, supporting share prices.

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While governments created the initial conditions for the falling-volatility regime, the investor

response to this assumed backstop reinforced and magnified the trend. For example, many

investors have directly shorted implied volatility, extrapolating the trends of the recent past.

Record-short positioning in VIX futures by non-commercial accounts (speculators) shows high

conviction in the view that volatility will fall further still:

Central bank policy also incentivized the writing (selling) of equity options as a means of

generating income in a low-interest rate environment, which further suppressed implied equity

volatility. In the context of our prior example, the seller of the same equity option collects the

premium (paid by the buyer of insurance) in the event that the market fails to move significantly

during the term of the option. When there are more eager sellers than buyers in the options

market (as is the case currently due to income-seeking behavior by investors), option prices and

implied volatility tend to fall.

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The following chart shows the total assets under management (AUM) of Morningstar’s “option

writing” mutual fund category. While the overall AUM remains modest at $25 billion, the

growth trajectory indicates improving sentiment towards these kinds of strategies, with a

doubling over the last 5 years. This is taking place outside of the mutual fund industry as well,

e.g. via separately managed institutional accounts.

Lastly, and arguably most importantly, the increase in assets managed by quantitative funds has

also magnified the falling volatility trend. Per the chart below, quantitative hedge fund

strategies are nearing $500 billion under management.6 This is a significant size when

considering associated leverage and the frequent trading of quantitative funds - meaning their

impact is quite large as a fraction of daily trading volumes.

6 Note that this chart only covers the hedge fund industry and does not include risk parity AUM, which JP Morgan

estimates at ~$500 billion.

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Quantitative strategies that target certain levels or ranges of portfolio volatility, such as risk-

parity, equity market neutral, trend-following, statistical arbitrage, and global macro, create a

reflexive pattern in market volatility. In The Alchemy of Finance, legendary investor George Soros

relates “reflexivity,” or the circular relationship between cause and effect, to the performance of

economies and markets. Rather than promoting homeostasis, i.e., moving markets toward

equilibrium as proponents of the efficient markets hypothesis suggest, investors become caught

in mutually-reinforcing feedback loops between their expectations and the variables to which

those expectations refer. For example, if investors believe a company is creditworthy, the

market will price that company’s bonds at a lower interest rate, enhancing the company’s ability

to pay that interest (thus making the company more creditworthy). The same process works in

reverse, with negative investor sentiment towards a company (or country) exerting an upward

influence on interest rates and reducing the entity’s actual ability to pay. Examples of such

mutually-reinforcing processes are frequent in economic and financial history, and tend to

create massive swings in asset prices (booms and busts) that are inconsistent with an

equilibrium model of the economy and finance.

The mechanism for a similar feedback loop between risk-targeting funds and market volatility is

as follows: these funds project the future volatility of portfolio assets, usually using a measure of

rolling historical volatility (for example, market volatility over the most recent 90 days). This

volatility “expectation” determines the amount of exposure held by the fund. For example, in a

falling-volatility market, the fund will need to add market exposure to reach the same target

level of volatility. If this is done on a broad enough basis across the industry, the increased bid

for assets (e.g. stocks) has the effect of driving markets higher and pushing actual market

volatility even lower.7 This even-lower level of volatility is then fed into the trailing volatility

models of the same risk-targeting funds, which causes them to increase exposure further in

order to hit volatility targets, and so on.

In an environment where quantitative funds represent an increasing fraction of assets under

management, and also (and more importantly) a larger share of daily trading volumes, the

7 There is an empirically negative correlation between stock prices and volatility. One common interpretation of

this relationship is the “leverage effect” of equity values (stock prices) on corporate leverage ratios. As a stock’s

price declines, the company in effect becomes more leveraged because the value of its equity declines relative to

the value of its debt. Therefore, volatility should expand in concert with the falling share price to reflect the

company’s increasing financial risk. There is some disagreement within the academic community regarding

whether this theory passes muster in practice. In any case, the inverse price/volatility relationship is quite reliable,

suggesting that widespread buying (or selling) of assets by quantitative funds (as in our example above) is expected

to influence asset volatility down (or up) in the process.

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impact of this reflexive loop on implied equity volatility, realized equity volatility, and equity

valuations is significant. Per Soros: “Typically, a self-reinforcing process undergoes orderly

corrections in the early stages, and, if it survives them, the bias tends to be reinforced, and is less

easily shaken.”8 This perspective sheds light on the persistent fall in volatility (with progressively

less severe spikes) that we’ve seen over the past nine years.

The explosion of passive investing has contributed to reduced equity market liquidity, with

implications for volatility and the market impact of quantitative strategies. The following chart

shows the AUM of the SPDR S&P 500 ETF (SPY), one of the largest passive funds in the world,

minus the AUM of the Fidelity Contrafund, one of the largest active funds in the world. We use

this metric to proxy the relative growth of passive investing. The industry-wide reallocation

towards funds with much more limited daily trading activity has contributed to a drop in equity

market liquidity over time:

In the context of volatility, lower volume is a double-edged sword – on one hand, when major

events are able to move markets in a certain direction, the move should be significant because

the market is not liquid enough to absorb the influx of buying/selling activity. This is known as

gap risk. On the other hand, reduced daily trading activity in the markets due to the rise in

passive investing implies lower market volatility on average: if there isn’t cause for the market to

move (buying and selling activity), it won’t. Ceteris paribus, the result is subdued volatility most

of the time, with the potential for infrequent, but large, spikes.

8 Soros, George. The Alchemy of Finance. Simon & Schuster, 1988; paperback: Wiley, 2003.

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To summarize:

1) Government intervention in financial markets has suppressed both realized and implied

volatility by reducing the assumed likelihood of adverse market outcomes. Investors

perceive a narrower potential range of market prices, and have little reason to purchase

insurance for their portfolios.

2) Investors’ response to the government-engineered low volatility regime was,

unsurprisingly, to sell volatility. This is evidenced by the growth in option-writing

strategies and the record-short position in VIX Index futures.

3) The growth of risk-targeting portfolio strategies (a facet of most quantitative funds)

reinforced the drop in volatility in reflexive fashion.

4) The rise of passive investing has contributed to subdued equity market liquidity,

increasing the potential for market dislocations.

These forces have contributed to:

(1) A discrepancy between volatility and other measures of uncertainty;

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(2) A departure of asset values from economic and corporate fundamentals;

and (3) Increasing leverage among complacent investors.

How will these excesses be resolved? Let us reference Soros once more: “When the (reflexive)

process is advanced, corrections become scarcer and the danger of a climactic reversal

greater…Eventually, conviction develops and is no longer shaken by a setback in the earnings

(fundamental) trend. Expectations become excessive, and fail to be sustained by reality. The

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bias is recognized as such and expectations are lowered. Stock prices lose their last prop and

plunge. The underlying trend is reversed, reinforcing the decline.”9

In other words, once the gap between expectations (e.g. current market volatility) and

fundamentals (corporate, economic and geopolitical conditions, which argue for a higher “fair

value” of market volatility) becomes too wide to sustain itself, there should be a corrective move

higher in volatility which is large enough to change expectations and reverse the trend. The

process described above could become reflexive in the opposite direction, as higher levels of

trailing volatility force investors to de-risk their portfolios, leading to higher volatility, leading to

more de-risking. The exit of long equity and short volatility “tourists” will exacerbate the decline,

particularly since markets have become less liquid. Passive investors, who thought they could

live comfortably with a “set it and forget it” portfolio, may become sufficiently unnerved by the

violence of the correction to abandon their strategy. An infamous (and similarly reflexive)

analogy comes to mind in the role portfolio insurance played in the 1987 crash, though reflexive

boom/bust cycles have appeared and reappeared in different manifestations throughout

financial history, including 2000 and 2008.

KPF Global Strategy

Though we have identified an alarming distortion in equity volatility, government intervention

will be a feature of the market as long as doves control the Fed (and other central banks) and

Keynesians control governments everywhere, making the timing and path of the eventual

unwind difficult to foresee. In other words, we expect officials to continue to attempt to curtail

sharp declines in equity markets. However, in the spirit of Nassim Talib’s Antifragile, we do not

think the repeated neutralizing of economic and financial risk is a path to permanent market

tranquility, but rather sows the seeds for larger problems down the road.

Therefore, we are maintaining a prudent cushion of cash, but are also looking for ways to extract

returns in a market that could conceivably drift higher or trade sideways for some time. This

means remaining invested in foreign equity markets. Though these markets are more volatile

than the US, they also offer better value. Always, but particularly in an environment where

measures of volatility are deceiving, we view risk as permanent loss of capital. The risk of

permanent loss varies inversely with purchase price. In other words: value investing works.

9 Soros, George. The Alchemy of Finance. Simon & Schuster, 1988; paperback: Wiley, 2003.

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Conversely, we are underweight the areas of the portfolio which are overvalued and especially

exposed to deleveraging by quantitative strategies (i.e. risk parity funds and CTAs), such as US

equity and long-term bonds. Despite the increased risk of an equity market correction, there

isn’t much mileage in buying bonds with the 10-year rate near 2.2%. We will reconsider this

stance in the event of a renewed rise in yields toward 3%.

Assuming rates and/or volatility do rise to more reasonable levels, we are also planning to

initiate a new strategy of writing covered calls against high-dividend, defensive equity

exposures. This strategy offers a significant yield pickup in the event of a sideways market, and

should outperform the market on the downside.

Finally, in order to hedge equity market exposure in client portfolios, we are researching a long-

volatility strategy which is significantly more cost-effective than a traditional put option strategy.

Such a hedge is designed to profit (and protect portfolios) in a rising-volatility environment

while requiring few changes to core exposures.