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As we wrote last year, the pandemic and the resulting global economic shutdown brought bouts of market distress and dislocations that created investment challenges but also potential opportunities for alternative strategies. While we are not yet on the other side of the pandemic and the related economic implications, we think it’s worth considering some of the other market and industry dynamics that are likely to impact the environment for alternative strategies in the months and years ahead.
In particular, we continue to see mounting evidence that risk assets are becoming more illiquid in risk-off environments — a trend that predates the pandemic, is likely with us for the longer term, and may have a number of potential implications for alternative strategies.
“Walking with soup”
The COVID-driven market sell-off was just the latest in a long line of events that have highlighted the lack of liquidity in the market when it was needed most and the impact this can have on market behavior. In recent years, we’ve seen market sell-offs accelerate into more severe market downturns — in February 2018 (“Volmageddon”), the fourth quarter of 2018 (initiated by Federal Reserve rate hikes), and May 2019 (US/China trade tensions), to cite a few examples.
Figure 1, from our Global Derivatives Group, illustrates the changing relationship between the volatility environment (proxied by the VIX) and liquidity (based on the average level of futures liquidity). We see that for a given level of volatility, the average level of futures liquidity was significantly lower in the second half of the past decade than in the first half; the effect is particularly pronounced at higher levels of volatility.
The liquidity challenges can be traced to a number of profound changes in capital market structure and the asset management/trading ecosystem. Following the global financial crisis, regulatory action forced broker-dealers to greatly curtail their market-making activity. Gradually, we saw the emergence of the market-making role with certain systematically oriented trading firms, who have smaller amounts of capital behind them and, as a result, are programmed to be highly risk-averse, withdrawing liquidity when volatility rises to avoid “catching too many falling knives.” At the same time, we’ve seen a proliferation of strategies (CTA, volatility targeting, volatility managed) that have a propensity to demand liquidity when volatility is rising.
When volatility is low, there is no problem, but it doesn’t take much for higher volatility to drive down the supply of liquidity and simultaneously drive up demand for it. This results in larger-than-warranted moves to the downside, which in turn produce more need to sell/de-risk and so on. As our colleague Gordy Lawrence, director of Global Derivatives, put it, “If you’ve ever tried walking with a hot bowl of soup, everything is fine as long as your gait remains stable, but once you hit a bump and the soup starts sloshing back and forth, it’s pretty hard to get it to stop before it spills over the edge.”
What it means for markets and the role of alternatives
As trading continues to become more concentrated and algorithmically driven, we would expect the potential for sharp drawdowns to grow. We would also expect correlations to trend up over time, driving potentially larger dislocations.
Another consequence of these market-plumbing issues may be less efficient market pricing. Over the short and medium term, pricing increasingly seems to be a reflection not of fundamentals but of liquidity.
Against this backdrop, we think investors may want to consider several ideas for their alternatives portfolios:
- Given the potential for more drawdowns, risk-mitigating strategies may become increasingly important, including market-neutral strategies and/or strategies that aren’t correlated to risk markets. Investors may also see a growing role for tail-risk-protection strategies.
- There may be a growing role for specialized strategies that can exploit these broader trends. This may include fundamental long/short stock-picking strategies that can distinguish between winners and losers amid liquidity-driven price dislocations. In addition, while the market volatility spurred by the trends discussed above may create challenges for risk-asset performance broadly, we would also expect it to lead to greater dispersion across and within sectors, potentially making for a more fruitful environment for bottom-up stock picking by long/short managers.
- When liquidity is constrained across market subsectors, some credit relative-value strategies may benefit by serving as liquidity providers without assuming directional exposure to the market overall. These managers may be able to identify disconnects between market prices of dislocated securities driven by liquidity considerations and what they consider sensible clearing prices for those securities based on fundamentals.