At 2:32pm on May 6, 2010, the S&P 500 careened 8% in just 36 minutes before rebounding with just as dramatic of a move. The reason for this extreme volatility, according to market pundits, is that algorithmic trading firms step away from the market when they sense instability. Paul Britton of Capstone points out that, “Banks have moved from being warehouses of risk to being intermediaries, … markets are riskier now as a result.” Banks have stepped away from providing liquidity in markets especially when markets become volatile.
Since the financial crisis, investment banks have retreated from their historic role in buying and selling equities to using computer algorithms to quickly withdraw bids/offers when markets become volatile.
Another example of this illiquidity occurred on February 5, 2018 when liquidity in the futures market dried up in anticipation of the end of day rebalancing of VIX ETPs. This ultimately led to a 4% drop in the S&P 500, a 116% rise in the VIX, and the demise of XIV.
According to Bank of America, from 1929 through 2008 the market has experienced a high fragility event, a sharp shock to the S&P 500, at least once per decade. Since the global financial crisis, high fragility events have become far more common. In fact, we have seen four such events in the last ten years, with the third largest in history occurring in February of 2018 shown on the graph below.
The hard truth is that the depth of the U.S. stock market has deteriorated markedly. The following graph shows the average number of S&P 500 futures contracts quoted close to the current price. 2018 exhibited one of the worst liquidity environments since 2008, which may explain the extreme levels of volatility we saw throughout the year.
Many experts have argued that the new regulations have attracted more market makers, which has made the markets tighter between the bid and offer spreads; however, Thomas Peterffy, founder of Interactive Brokers, would disagree. He has criticized exchange rules for putting dealers at a disadvantage to “small, predatory investors with faster computers.” These small algorithm firms have improved the spreads in normal orderly markets, however, during volatile times, market makers have disappeared, resulting in a loss of liquidity.
In a sign of this trend, Timber Hill, a U.S. options-market-making subsidiary of Interactive Brokers, was recently sold to Two Sigma Securities, a $30 billion hedge fund. Consolidations like this are occurring across the industry and are a cause of concern to market participants, who worry what will happen when larger market makers step away and cease to provide liquidity during times it is needed most.
A Losing Strategy
An advisor constructs a portfolio trying to balance risk and return, however, the average advisor knows that their correlations will all converge during high fragility events. A second problem is preservation of capital. As markets draw down, the advisor is under pressure to reduce risk, especially as correlations do converge.
The data supports that professional advisors tend to reduce risk at exactly the wrong time. The following chart, shows that during the October 2018 selloff, there were massive outflows on December 12, just weeks before the market bottom. If the advisor went into cash or debt in December near the bottom, the subsequent rally could put the advisor in a losing position, locking in their losses. Market timing has consistently shown to be a losing strategy, yet an advisor caught in a deep sell off is left with no other alternative, as all assets start to fall together and losses become unbearable. Although the advisor tells the client to stay the course and invest for the long term, there comes a point when the client says they can’t afford to lose any more money, forcing the advisor to sell equities.
Adding Insurance to a Portfolio
Adding insurance to a portfolio has always been an expensive proposition. Funds like Prudent Bear and Hussman that are designed to provide insurance, or a hedge, to a portfolio do move higher in a market downturn, yet inevitably get pummeled as the markets grind higher. Can an advisor add a fund to a portfolio that will make money in up markets without getting destroyed when a high fragility event occurs?
A Strategy Designed for High Fragility Events
The only reliable way to protect a portfolio from a flash crash event is to always hold insurance (protective puts) through good as well as bad times. An asset that can hold the proper balance of protective puts to prevent losses from a high fragility event while still making money in up markets would be a great addition to any portfolio framework.
Flash Crash Protection
IPS Strategic Capital has developed the IPS Absolute Return Strategy (IPSAX) which holds two times notional of its AUM in long protective puts. As exhibited in the table below, during high fragility events the strategy has proven to hedge risk.
As the market has drawn down, the strategy on average has lost less, and in drawdowns of greater than 4% it has actually made money. Using conservative assumptions to backtest how the strategy would have performed if the market had another 1987 event, we see the ideal situation of profiting regardless of market direction (graph below). Of course, past hypothetical performance is not a guarantee of future returns. By continually holding long protective puts, we don’t have to worry about timing or predicting the next market crash, because we are always wearing seatbelts and prepared for the next crash.
One doesn’t buy insurance when they need it, they buy insurance for when they will need it. By always holding protective puts, our strategy protects against any type of high fragility event that would destroy a client’s portfolio. Just as important, a decision to use the strategy and remain invested without the risky proposition of market timing eliminates the risk of the advisor pulling his clients out of the market at the wrong time.
Adding a strategy which provides continual, defined downside protection and has historically shown to also participate in up market gains can strengthen any portfolio framework and provide peace of mind to investors and advisors alike.