Howard Marks, founder and chairman of Oaktree Capital Management, wrote in a recent memo that the biggest danger to investors is their willingness to buy risky assets that are likely to provide low returns. Market conditions may not fully reflect current risk; option prices, for example, are very low. Some firms – notably PIMCO – recommend investors buy put options to protect their portfolios. I propose an alternative strategy that will be resilient to the potential shocks of increased volatility and higher interest rates, without incurring the cost of options.
The risk cycle
Investor attitudes fluctuate between risk tolerance and risk aversion, Marks says. When markets are rising, investors take on ever-greater levels of risk and volatility declines. Eventually, however, prices outpace demand, and the market turns. As assets get cheaper, investors deleverage and become increasingly pessimistic. Marks’ explanation of the risk cycle is consistent with Hyman Minsky’s financial instability hypothesis.
One implication of this view is that asset quality may not be a good predictor of future risk. Marks cited two specific cases to illustrate this assertion:
- In the late 1960s, the “Nifty Fifty” stocks were considered to be an excellent core of a portfolio because the underlying companies were high-quality investments. Enthusiasm for these 50 stocks drove their valuations to astronomical levels (price-to-earnings ratios of 80 and above). Investors who purchased those stocks suffered major losses when prices subsequently declined. Investor complacency in loading up on these assets led directly to their collapse.
- As a second example, Marks noted that junk bonds were undervalued in the 1970s because they were considered too risky. Since the late 1970s, though, high-yield bonds have enjoyed consistently strong performance, even though they are low-quality assets.
Both price and asset quality matter. Low-quality assets at low prices may be a much better bet than high-quality assets at high prices. That lesson is critically important today. Treasury bonds, for example, are high quality, but this does not mean that investors can afford to be indiscriminate with regard to their current yields.
Another lesson to be learned from Marks’ theory of the risk cycle is that reaching new lows in volatility of risky assets is a major warning sign.
Where we stand today
Marks’ assessment is that we are experiencing an unusual state of the risk cycle. Investors – individual and institutional – are investing more aggressively than they have in recent years, according to Marks.
“The good news is that today’s investors are painfully aware of the many uncertainties,” Marks wrote. “The bad news is that, regardless, they are being forced by the low interest rates to bear substantial risk at returns that have been bid down.”
With yield-starved investors turning to high-yield bonds in recent years, companies are finding it cheaper to issue low-grade debt and leverage up.
While Marks is focused on the fixed-income side of the market, his assessment has implications for equities and other asset classes. “ The wise man invested aggressively in late 2008 and early 2009,” he wrote. “I believe only the fool is doing so now. Today, in place of aggressiveness, the challenging search for return should incorporate goodly doses of risk control, caution, discipline, and selectivity. “
Measuring risk aversion
Analysts typically look at yield to measure risk aversion. Lower yields mean investors are accepting less income in exchange for taking on risk. Risk aversion can also be measured by looking at volatility. When investors are uncertain or worried, volatility tends to be higher. When investors are complacent, volatility tends to be low.
I will use both yield and volatility to measure risk aversion. The two metrics are related: Yields and volatility tend to rise in tandem in response to increased risk. If investors are essentially indiscriminate with regard to risk in their search for yield (which is referred to as “yield chasing”), both yield and volatility will decline. Marks is concerned that the current decline in volatility has less to do with decreasing risk in the underlying assets and more to do with investors becoming too risk tolerant.
Option prices depend on investors’ perception of future risk. When investors perceive the future as riskier, options are more expensive, and vice versa. The VIX, a standard measure of volatility, tracks the volatility of options on S&P 500 stocks that are nearest to expiration. The VIX is highly correlated to recent historical volatility in the S&P 500. The chart below shows the history of VIX along with trailing one-month, two-month and three-month realized volatility in the S&P 500. While the correlation is far from perfect, it is very strong — between 88% and 89% in all three cases.
VIX vs. Trailing 1-, 2-, and 3-Month Volatility in the S&P500
The most striking feature of the chart above is the huge spike in both realized volatility and the VIX in late 2008, when the market crashed. It is also notable that in 2007, the VIX was a low as 10% and realized market volatility dropped well below 10%.
It is well-documented that implied volatility tends to be higher than realized volatility. We see this effect clearly when we look at the aggregate percentiles of VIX versus trailing volatilities for the S&P 500 (using the exchange-traded fund SPY).