When markets are scary, bet on volatility
It may be hard for some of us to remember, but share prices, commodities and other assets used to move on the basis of their intrinsic value.
That hasn’t been the case for the past eight years, as governments have got involved in financial markets like never before. As a result, markets continue to move based on where people think policy- makers will or will not intervene.
When the U. S. government was throwing tons of money at mortgage- backed bonds, for example, that market was the place to be. But as Ari Shiff at Vancouverbased Inflection Mangement Inc. points out, central banks in many countries have generally run out of ammunition.
As the population grows more restless amid ongoing levels of high unemployment, austerity, slow growth and limited opportunities, investors are also becoming more aware that the “fundamental plumbing” that led to the financial crisis of 2008 has not been fixed.
Things may have i mproved dramatically in the U.S. and elsewhere since, but Europe is an example of a region where structural challenges are perhaps only beginning to be addressed.
Shiff, whose firm runs the Inflection Strategic Opportunities Fund — a fund of hedge funds that typically focuses on three or four themes and managers that use related strategies — sees this as a primary source of the elevated volatility currently impacting many markets.
“When you get a population that is unstable and unhappy, it doesn’t take much for them to rush toward one extreme or the other,” he said. “When you have a flat sea, a little ripple can become a big wave very quickly.”
The Chinese equity markets serve as Exhibit A for volatility, but real economic data across the globe makes it clear that we’re in a lowgrowth period, which tends to make people unsure of where things are going.
That’s why Shiff and Inflection’s Jamison McAuley, are steering the portfolio toward strategies that have a low dependency on equity and bond market performance, while at the same time offering Canadians an option for diversifying their investments.
With equity-market valuation metrics looking to them a lot like 1929, 1965, 2000 and 2007 — all of which tended to be followed by a decade of poor returns, and the riskreturn trade-off looking very poor on a historical basis in the bond market, Inflection is staying away from those areas.
Instead, they’ve allocated capital toward volatility specialists — managers that perform best when volatility is the highest.
One way to capture this volatility is through mean reversion on a short-term time scale, such as three days or less.
Whether it’ s redemption sand forced selling at a high- yield bond fund, or short covering as investors get squeezed out of a rising stock, asset- price moves often tend to overshoot.
“That creates an opportunity to bet that the price is going to swing back the way it came in the very short term,” McAuley said. “Those types of moves can be very profitable for active traders, and one of our managers says this is the best time to do so since 2007.”
Inflection is also focusing on niche markets encountering elevated volatility, including municipal bonds, structured credit and energy.
While the firm tends to avoid the energy sector, extreme volatility there has made the opportunity too attractive to pass up.
The fund has allocated capital to an energy-products trader who has built a proprietary supply and demand model that tracks both the upstream and downstream networks for oil.
“He counts barrels of supply and demand, then looks at market prices to deter- mine where the inefficiencies are,” McAuley said.
That can result in a directional trade — prices moving up or down, a relative value or arbitrage-type trade such as European oil looking cheaper than U.S. crude, or a time spread such as if oil in 2018 looks undervalued relative to 2016.
Structured credit strategies that try to capitalize on the unintended consequences of the shift toward less accommodative lending, are one of Inflection’s highest conviction ideas these days.
The firm found a manager within a very large credit firm, that runs a small strategy able to short the credits of weakening companies.
“They looked for companies with flawed balance sheets that likely wouldn’t get refinanced, or when they did, it would be a much higher rates,” McAuley said.
“As soon as it becomes more expensive for them to be on life support, they are having the legs taken out from under them,” Shiff added.