August was a month of extremes: range-bound equity markets; high intraday volatility; U.S. 30-year bond yields hitting record lows; yield curve inversions; negative-yielding debt hitting record levels. All of this contributed to an elevated level of anxiety in financial markets.
Although the S&P500 Total Return Index ended down 1.58% in USD for the month (down 0.45% in Canadian Dollar terms), we witnessed three daily declines of more than 2% over the period. In the first full week of trading, we encountered intraday swings of greater than 1% on every single day. All-or-nothing trading days were the norm in August 2019. In a matter of minutes, equity markets could reverse course, switching from deep in the red to heavily green – or vice versa. This all led to higher intraday volatility and consequently perceived risk magnified for any type of model aiming at managing volatility.
August began with that weird feeling of déja vu in which investors got caught by another tweet by Trump. Slapping an additional 10% tariffs on $300B of Chinese imports starting on September 1st was enough to drag down equity markets significantly. It was a bad start for a month in which investors were caught up watching two of the most powerful men in the world puff out their chests. Investors got some relief in the form of information leakage about trade talks going well but those feelings were often short-lived. Amid Trump’s accusations of China manipulating the Yuan and China doing everything in its power to make Trump’s life more difficult in the months leading up to the election, investors were the ones who suffered.
All the noise around trade talks was a major driver of equity markets over the month, making August a month of more volatility and a lack of momentum. It was a period where traders would get hit chasing trends in equity markets; big gap downs were followed by renewed optimism either fueled by Trade War related tweets or an accommodative Fed. Yet, despite all this volatility, markets were essentially rangebound from month beginning to end.
Momentum in the volatility space was also fleeting. Below we see the implied volatility of a 100% moneyness option on the S&P500. We can see how unstable volatility has been, whipsawing back and forth into an oscillatory behavior not seen in years.
The same pattern was observed on the intraday volatility metrics studied. From a risk perspective, these large reversals lead to unfavorable forecasts of future volatility; however, this type of environment could foreshadow further risk down the road.
Throughout August, the cost of protection was considered “expensive” under our different convexity models. Prices per unit of delta were high and volatility of volatility made it hard to monetize any gap-risk protection. At the beginning of the month the volatility curve was upward sloping, then went into backwardation before coming back close to flat across maturities. For all these reasons, we did not buy protection in the form of put options over the course of the month.
Headline risk is common to every strategy. To our knowledge, “tweet-driven” markets are not favorable to any type of risk management techniques; however, for an investor looking at maximizing a certain reward-risk ratio, dynamically hedging using short-term (intraday) volatility targeting techniques remains a compelling option. Thinner tails and lower drawdowns are among the main benefits of such techniques which are incremental to returns in the long-run.
Behavioral biases such as overconfidence, loss aversion, and anchoring are not likely to go away, and equity markets will, at some point, break from this range. We fundamentally believe these types of anomalies will continue to prevail in financial markets and that effective risk management can benefits from them.
Despite all the noise created by the trade wars and Twitter Storms, the fundamental principles behind our risk management strategy remains intact. It's been empirically proven that periods of high volatility are detrimental to performance; hedging against this volatility is thus beneficial in the long term. As trade tensions are expected to persist and a broad spectrum of economic indicators are pointing in different directions, we expect financial markets to remain volatile over the foreseeable future. We will thus hold our course and continue managing our funds systematically, even through extreme times.
The Systematic Investment Strategies Team
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