Tuesday, February 4th, 2014

The Mechanics of Risk

We regard the events of January as a classic “risk-off” episode. We think the underlying cause of the sell-off is the Fed taper, rather than anything nasty in the woodshed of global finance – though this may yet be uncovered. Our model has increased its exposure to all fixed income assets (including emerging market bonds) and reduced its exposure to global equities – even low-beta markets like the US and the UK, where the risk of contagion (whatever that means) is small.

Within equities, the regional ranking is exactly the same as the start of January: first the Eurozone, followed by the UK and US in equal second, then Japan, then Emerging Markets. The order is virtually the same no matter whether the portfolio is denominated in euros, sterling or US dollars. Fixed income rankings are equally unaffected. For all portfolios we rank the categories in the following order: first high yield (where available), then investment grade corporate bonds, then domestic government securities and finally emerging market bonds. Again, this ranking is unchanged since the beginning of January. Investors have not altered their preferences within equities or bonds, only the proportion in which they allocate between them.

We think the reason for this is risk, specifically the excess volatility of equities versus bonds. We use this as the hurdle rate to determine whether equities represent a risk-efficient investment. When excess volatility rises, investors will normally sell equities and re-invest in bonds, even if the relative returns remain unchanged. But it hardly ever happens this way. It is far more normal for excess returns to decline at the same time as excess volatility increases – and that is exactly what happened in January. The volatility of all equity markets went up while the volatility of all fixed income markets fell (including emerging market bonds). The hurdle rate goes up; investors sell-equities and buy bonds.

So why does this feel like a crisis? Conversations with our clients suggest that nearly all of them entered January with a level of risk which was at, or close to, the maximum allowed by their mandates and that many who normally had a policy of hedging equity risk had much less portfolio insurance in place than in early 2013. Any significant risk-off episode would have forced them to react, because they had no slack. Now it has happened, they have become concerned that this episode may be followed by others later in the year. We think this is actually the second episode, the first having occurred in early December – just before the Santa rally.

This can all be summed up with one statistic. The excess volatility of US equities over US bonds (26 week trailing) is currently 4.4%, compared with the 18-year median of 9.9% and a first quartile reading of 6.4%. If the Fed continues the taper, risk conditions will normalise as we move through 2014, which means the hurdle rate for risk-efficient returns must rise. Unless returns accelerate, which is unlikely after the annus mirabilis of 2013, investors will be forced to adopt a more neutral balance between equities and bonds.

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