In the second part of an interview, Herve Guyon, who works in flow strategy and solutions at Societe Generale, explains risk parity strategies and the implications of volatility in the S&P 500
"What changed the environment earlier this year was the surprisingly high reading for wage inflation in the US, which triggered a sell-off in the bond markets (because higher inflation is bearish for bonds)," said Herve Guyon (pictured), flow strategy and solutions at Societe Generale. "Higher yields also affects the equity markets through the mechanical valuation effect. The combination of the bond and equity selloff finally triggered selling pressures from risk parity strategies.
"There is a massive volume traded in risk parity strategies, where investors are typically 60% long on bonds and 40% long on equities," said Guyon. "This exposure is adjusted in line with the realised volatility of each underlying, which means that, if the bond market becomes volatile, you will decrease that exposure and the same with the equity exposure. The global leverage also depends on the correlation of the two assets: the more correlated the less leverage."
When bonds and equities began to move in a correlated manner, the portfolio becomes more volatile, so, to maintain the same level of risk, these strategies need to sell not only bonds but also equities, according to Guyon. "That is what happened back in February, and it was quite ironic, because it was triggered by positive news on the macro front after years of lack of inflation," said Guyon. "Since the financial crisis, inflation has been the missing part of the economy raising question about the current relevance of the Phillips curve."
This mechanical sell-off triggered more volatility in the S&P 500, which was exaggerated by the fact that Vix ETPs were actually buying Vix futures for size, after a significant move on the upside, according to Guyon. "We saw increased demand for forward start variance on the S&P 500," said Guyon. "In the current environment, investors don't want to be long on volatility via position that are potentially expensive in terms of carry, but they think that at some point this environment will change and people will have to unwind their short positions. The risk of positive equities-bonds correlation on the downside could potentially amplify the moves in the future."
Another big talking point this year has been how a change in the correlation between rates and equity can bring more demand for implied volatility as investors cannot rely on fixed income to hedge their equity portfolios anymore, according to Guyon.
"If you are in a post-Lehman Brothers default or February 2018 scenario, the asset to hedge is volatility and investors should buy put options," said Guyon. "The other reason we like volatility on the S&P 500 is the high leverage in US medium and small caps, which might suffer at some point with higher rates. SG remains bearish on the S&P 500 compared to the rest of the street, and that's why we think forward start volatility on the S&P 500 is the instrument of choice at this time."
Leverage ETP strategies on the Vix worked as expected during the February spike but some investors were caught by surprise, according to Guyon.
Furthermore, risk control strategies can protect investors from sudden volatility moves, but can also contribute to the selling pressure when there is a sell-off, according to Guyon. "As the market becomes more volatile, exposure is adjusted as a function of realised volatility. We see strong demand in the US for volatility control indices, especially around long-dated products, such as variable annuities."
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