Volatility, which has become the main measure of risk over the last two decades, is very likely overrated, according to some experts who believe the ongoing rise in market volatility is simply hiding -- and revealing -- deeper and more unsettling risks.
Harry Markowitz introduced in 1952 his mean-variance model in which asset classes were the key portfolio building blocks. Since then, theoreticians have tried to optimize portfolios by replacing Markowitz’ classic asset-class-based allocation approach with models that integrate factors such as valuation, momentum, credit spreads, etc., say Thomas Idzorek and Maciej Kowara in a 2013 Financial Analysts Journal article titled Factor-Based Asset Allocation vs. Asset-Class-Based Asset Allocation. Idzorek is president and chief investment officer at Morningstar Investment Management, and Kowara is a portfolio manager and research director at Transamerica Asset Management; both are in Chicago.
Their paper shows that neither approach is inherently superior to the other. "Authors who strongly suggest that risk-factor-based asset allocation is inherently superior," Idzorek and Kowara write, "are at best over¬stating their case and at worst confusing investors with a false value proposition." Volatility, they note, is one of the latest "factors du jour," along with relative liquidity. "The problem," adds Paul Kaplan, director of research at Morningstar Canada, "is that people tend to become overly enthusiastic with one measure."
Such is the case with volatility, claims Fiona Frick, chief executive officer at Unigestion, in Geneva. "Volatility is a bad proxy for real risk, she says. Quantitative models have simplified the issue by using volatility. But it is a backward-looking measure, and people take for granted that historical norms will just continue in the future."
"People just love mathematics; they're so reassuring," says Jean-Pierre Couture, chief economist and emerging markets portfolio manager at Hexavest in Montreal. Sure enough, volatility as a risk measure works 80% of the time, "but not when you need it most, when tail events kick in," he adds.
Things have evolved to a point where volatility is the key determinant of portfolio allocation and has overtaken classic asset-based allocation. Managers of the millennial generation have been trained only according to recent financial engineering notions, thinks Couture. "They diversify not in terms of weakly-correlated assets, but in terms of weakly-correlated risks. If things go wrong, everyone will want to sell the same assets all at the same time."
That can lead to regrettable unbalances. For example, a manager's risk-based allocation could prompt him to concentrate too much of his portfolio in a single class of assets, causing his portfolio to suffer unduly if markets tank.
That leads Fiona Frick to say that the risk measure of volatility itself now creates risk. "More and more people are looking at the same signals, which will create systemic risk," she says, adding: "It tells you more about the perception of investors and how they feel than about the market itself."
That's why she adopts a "holistic" view of risk that keeps a close watch on markets' liquidity levels, stress levels and, foremost, what real loss one's portfolio could suffer. That has to do with "tail risks" and "value at risk" models, but with cold, calculating realism. It can tell you, for example, that you have a 5% chance of losing 10% or more of your portfolio's value. And that means you remember "or more", which "many tend to forget," quips Kaplan.
So, if volatility is not the real risk, what is? Frick and Couture think that it lurks in the corporate bond market. "Because of all the liquidity that central banks have created," Frick notes, "everything has been going up indiscriminately; volatility has been low and correlation high."
"The excess we've witnessed in the residential mortgage markets before the 2008 crisis, we now see them in the corporate bond market," says Couture.
Couture substantiates this with facts and figures borrowed from a June 2018 Washington Post article titled Beware the ‘Mother of All Credit Bubbles', by Steven Pearlstein, a professor of public affairs at George Mason University in Virginia.
Companies' net payments to shareholders have nearly doubled from 4.5% of revenues in 2000 to 8.7% in 2017, while capital expenditures have fallen from 6.3% to 5.6%. Along the way, corporate debt has reached record highs, steadily creeping up from 29.8% of U.S. GDP in 1952, to 73.1% in 2017. In 2008, U.S. corporate bonds totalled US$ 2.8 trillion; they now stand at US$ 5.3 trillion. "At least half of those new bonds have been either 'junk' bonds, the riskiest, or BBB, the lowest rating for 'investment grade' bonds," Pearlstein writes. "More than a third of the largest global companies now are highly leveraged -- that is, they have at least $5 of debt for every $1 in earnings -- which makes them vulnerable to any downturn in profits or increase in interest rates."
What does this all mean for investors?
Couture thinks we are facing a "Minsky moment", when complacency and low volatility inevitably lead to spiraling debt, which is quickly followed by high stress and high volatility. Frick disagrees. "We are still positive on equities, though we see more risk attached to them. This is not a Minsky moment, when everything falls at the same time."
Pearlstein is just as pessimistic as Couture. "It's hard to say what will cause this giant credit bubble to finally pop," he says, adding that "pretending it won't happen is folly."
Investors who still believe in stocks, as Frick does, should proceed to diversify judiciously, not so much in different assets, but in assets that react differently to common factors. "Strategies that reproduce cap-weighted indexes risk being exposed to overbought and overvalued positions," which will be vulnerable in a market correction. She believes in "buyout" investment in the non-listed segment of small and medium-sized companies, which exhibits a low correlation to index-listed stocks and high-yield bonds.
As for Couture, his portfolio is considerably underweight in Canada and the U.S., and overweight in international stocks. And, in preparation for the right moment to pounce when markets drop, "we are very high in cash," he says.
