Fri, 30/03/2007 - 06:58
Kostas Iordanidis, co-chief investment officer at USD5.4bn fund of hedge funds manager Olympia Capital Management, argues that the current level of complacency in financial markets is significant, as the correlation of many hedge fund strategies with equities indicates.
It is a challenging task to express views on market complacency. Over the past half a century, the foundations of finance theory have been built on the concept of efficient markets, with market prices being the reflection of the collective information on the prospective returns of financial assets. And yet despite academic orthodoxy, markets reflect not only the fair value of risk premiums for financial assets at any point in time but also the behavioural biases of market participants.
If we define complacency as the systematic mispricing of financial market risks by market participants for extended periods of time, complacency is the direct result of the behaviour of buyers and sellers in financial markets.
The financial literature has identified and analysed numerous such biases, all of which are innate, in the sense that they stem from the neurological hard wiring of the human brain. We are all familiar with investor focus on short-term performance, disregard of fundamentals and over-reaction to news.
At the extreme, such behaviour leads to financial bubbles that do not necessarily require investor irrationality in order to occur but they can happen even within in the framework of rational expectations (see for example Charles Kindleberger's excellent book, Manias, Panics and Crashes: A History of Financial Crises, Wiley 2005). Complacency is a necessary precondition that leads to financial bubbles.
Is there a way to simply measure complacency in financial markets? Perhaps the simplest measure is the level of option implied volatility of financial assets. We can think of implied volatility as the sum of two components: a forecast of the future realised volatility of the underlying financial asset, and an insurance premium that serves as compensation for the underwriter of the option (the floor trader or investment bank).
The following chart shows the daily levels of the VIX Index (a measure of the implied volatility of near term at-the-money S&P 500 options) over the past seven years. As the chart clearly demonstrates, equity implied volatility has declined precipitously over the past three years to a level of approximately 10 per cent, from an average level of 30 per cent in the 2000-02 period.
It is also evident from the chart that the slightest indication of market turmoil is enough for the VIX Index to spike upward. Indeed in June of 2006, with the equity market selling off, the VIX Index jumped to 24 per cent from 11 per cent in a few days.
The low levels of equity implied volatility over the past three years are my no means unique. As the following chart illustrates, equity volatility was at similar low levels in the 1992-95 period. What is also clear from this chart is that over the past 20 years that we have equity option data available, equity volatility has been at times significantly higher than current levels and never below 10 per cent on a sustained basis.
An analysis of US corporate spreads shows a similar pattern of complacency with respect to credit risk. The following chart shows the spread between Baa rated US corporate bonds and 10-year US treasury bonds over the past 37 years (the data come from the board of governors of the US Federal Reserve).
Again, after reaching historical highs in 2002 in the aftermath of the Enron and WorldCom bankruptcies, credit spreads have declined substantially to levels at which the risk premium offered for bearing credit risk is minimal.
In the case of credit spreads, we have the benefit of having historical data for almost a century. The following chart shows the spread between Baa- and Aaa-rated US corporate bonds starting in 1919. Again, financial markets are significantly discounting the risk of economic distress and elevated levels of corporate bond defaults.
The third area of complacency in the market place is related to the behaviour of hedge fund managers over the past two years. One of the most important recent concerns of investors regarding hedge fund investing has been the increase in correlation between hedge fund returns and the equity markets.
Indeed, over the past two years, the correlation between the HFRI Fund of Funds Composite Index and the MSCI World Index has increased significantly, from a level that was close to zero in early 2004 to 0.81 in December 2006.
The increase in correlation between hedge funds and equity markets has naturally also affected Olympia Star I and our other diversified fund of funds; the current correlation with the MSCI World Index is at an all time high of 0.79.
One of the factors that have affected the correlation between diversified hedge funds like Olympia Star I and equities is the significant increase in the correlation between bi-directional managers (global macro and CTAs) and equity markets.
This is not surprising since most of these managers are trying to profit from trends in different asset classes. Their large exposure to equities is related to the strong upward trend experienced by worldwide equity markets since 2003.
The following figure plots the three-year rolling correlations between the MSCI World Index and our universe of global macro managers, CTAs, and credit managers between January 2004 and October 2006. The red line - with scale on the right side of the figure - represents the three-year rolling volatility of the MSCI World Index over the same period of time.
The above figure vividly illustrates our conjecture on the origin of the increase in the correlation between hedge funds and equities. First, we can see that the correlation of credit and distressed managers that are not supposed to be highly correlated with equities has started to increase just after the start of the downward trend in the MSCI World volatility.
In addition, as the credit cycle matured over the past three years and credit spreads tightened significantly, managers in the space have been increasingly investing in post-reorganisation equities, thus increasing their equity market exposure.
Secondly, the historical correlations of bi-directional managers have gone from negative in 2004 to highly positive. For example, the correlation of Olympia's global macro managers with equity was at 0.77 by the end of October 2006. In an environment of diminishing opportunities in currencies and fixed income, global macro managers have increased their exposure to equities and emerging markets.
In summary, we believe that the current level of complacency in financial markets is significant, especially with respect to equity and credit risk, and portfolio managers should adjust their portfolios accordingly.
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