Two weeks ago we asked a question: maybe behind all the rhetoric and constant (ab)use of sophisticated terms like “gamma”, “vega”, CTAs, risk-parity, vol-neutral, central bank vol-suppression, (inverse) VIX ETFs and so forth to explain why despite the surging political uncertainty in recent years, and especially since the US election…
… global equity volatility, both implied and realized, has tumbled to record lows, sliding below levels not even seen before the 2008 financial crisis, there was a far simpler reason for the plunge in vol: trading was slowly grinding to a halt.
That’s what Goldman Sachs found when looking at 13F filings in Q1, when it emerged that the gross portfolio turnover of hedge funds had retreated to a record low of just 28%. In other words, few if any of the “smart money” was actually trading in size.
Over the weekend, JPM confirmed as much observing that, among other things, it was the retrenchment of active managers, who are being crowded out by central bank QE in the bond space and a shift towards ETFs in the equity space, that acts as long-term depressant of market volatility.
As the bank notes, since the Lehman crisis, the propensity to change positions or trade has declined as active managers have been crowded out by central bank QE, coupled with FX reserve managers’ and commercial banks’ purchases of bonds, all of which are crowding out active bond managers. This crowding out is illustrated in Figure 10 by the ownership of the $54tr universe of tradable bonds globally. 50% of this universe is owned by banks, central banks or commercial banks both of which are rather passive owners of bonds.
While the point is critical, what we would like to highlight in the chart below is the staggering amount of debt instruments owned by central banks: as of the latest data, central banks own just over a third of the global tradable bond universe of $54 trillion, or roughly $18 trillion. How this amount of debt on bank balance sheets is ever unwound, i.e. sold – even with central banks’ best intentions – without crashing the bond market, we don’t know.
And then there are ETFs, which have done to hedge fund equity holdings what central banks have done to fixed income crowding out: as JPM notes, “a secular shift away from active equity managers, mutual funds and hedge funds, towards passive equity mutual funds and ETFs. As we discussed before, this secular shift since the financial crisis of 2008 is driven by the inability of active equity managers to outperform established and well-known equity benchmarks such as the S&P500 index. Figure 11 shows this dramatic shift away from active equity funds towards passive equity funds in the US since 2008.”
JPM highlights that this crowding out of active managers, both bond and equity managers, has been reducing trading activity since the Lehman crisis. This is shown in Figure 12 by the trading turnover of DM equities and US government bonds, both of which have been declining secularly over the past eight years.
And this brings market liquidity, and volatility, into the discussion. The secular decline in trading turnover has been accompanied by a reduction in market liquidity and, in particular, market depth. In turn, reduced market liquidity and market depth is further discouraging active managers to trade or change positions as the transaction costs hurdle increases. And this reduced propensity to trade or change positions suppresses the average level of market volatility over the long run.
Which while perhaps acceptable in the long run, is a major risk in the short term, as reduced market liquidity can act as an amplifier of market volatility if a shock or surprise forces many investors to change their positions all at the same time. So market liquidity acts as a double-edged sword for market liquidity, and ironically the less liquidity, the less trading, which leads to even less liquidity and so on, until – at least in a “thought experimental” world – just one trade gets to “readjust” (in lieu of a more disturbing verb) the entire market.