Popular but dangerous investment strategies, 1987 and 2017

Only the most experienced investors in today’s markets remember what happened to US stocks on October 19, 1987. Known as Black Monday – the US market fell by 22% in a single day.

To put in some context, that year had seen the stock market rise by more than 20% in a very steady pattern, whilst the US and global economies enjoyed strong growth but muted inflationary pressures – market valuations had been rising for a few years and had reached historic extremes. In all these ways rather like 2017.

Institutional investors were enjoying the bull market but had concerns that it could not last and sought out strategies that could keep them invested whilst also protecting them from sharp losses. They hit upon the concept of “Portfolio Insurance” which made use of a recent innovation known as index futures. They created a strategy that remained invested until the market had fallen by a certain amount from its high, and then they would hedge their exposure by selling index futures; if the market fell further they would sell more futures.

During the long bull market of the mid-80s, these strategies did not really get tested, until October 19, 1987. There was no particular reason or news trigger for the market to fall, but once it was falling portfolio insurance programmes automatically generated sell orders that ensured that it fell further. That in turn triggered further selling and the stock market found itself inundated with accelerating volumes of sell orders. It took some banging of heads by the Federal Reserve overnight to restore sanity the next day.

It turns out that when a large number of investors all adopt a policy of selling when the market is falling and then selling more when the market falls further, then panic ensues, leading to sharp falls in market prices even if there is no fundamental economic reason for the market to fall.

For a while portfolio insurance strategies were put into abeyance, and the 90s was so caught up by the technology boom that nobody thought about protecting their profits!

In recent years however, a number of institutional investment strategies have come into common use that look likely to create the same effect of generating large and accelerating sell orders as market prices fall.

These strategies involve trading in volatility, an asset class that did not exist in the 80s. Equity volatility tends to fall as the market rises but volatility rises, usually very sharply, as equity markets fall.

“Risk Parity” strategies, are increasingly common. They aim to deliver balanced portfolios of equities and bonds where the risk of the total portfolio is split equally between equities and bonds. Achieving this and delivering acceptable returns requires the use of leverage. However, Risk Parity is a strategy that reduces allocations to bonds and increases allocations to equities as equity volatility falls relative to bond volatility and vice versa. In practice this means increasing equity exposure as equity prices rise in price and reducing equity exposure as equity prices fall.

“Managed Volatility” strategies focus on maintaining a constant level of volatility for an investment portfolio. Thus as equity volatility falls (usually associated with rising equity markets), the strategy requires adding more equities using leverage to maintain a constant portfolio volatility, and as equity volatility rises (usually associated with falling equity prices) the strategy demands reducing equity exposure. Buying as the market rises and selling as the market falls is merely replicating the effects of portfolio insurance 30 years ago.

Selling volatility has been such a successful strategy for the last eight years that there are now many investors who have enjoyed excellent returns from doing little else, and their positions are now very large. In a sharp market fall, volatility could double or more within a day, leading to substantial losses and covering of positions.

These can all be labelled “volatility-driven investing”, a21st century concept that has recreated market crash risk. They are increasingly used in todays’ markets. History may not repeat itself, but it surely rhymes. A sudden fall in equity prices and associated rise in volatility will lead to large buy orders in volatility and large sell orders in equities that will instantly extend the market fall into a market rout.