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es run themselves with similar risk management profiles and are able to, if they don’t like the opportunity set in front of them, simply shut down.” Barry Kenneth, chief investment officer of the Pension Protec- tion Fund (PPF), has observed those changes from the other side of the fence, having been a managing director at Morgan Stanley in the midst of 2008’s downturn. He also notes that banks’ are no longer as willing to take on risk. “Banks almost act like brokers rather than intermediaries,” Kenneth says. “In good times they provide capital to intermediaries, but when things become stretched and markets become extremely vola- tile the tendency to take on risk is a lot less than we would nor- mally see,” he adds.


The tendency of sudden market movements is further aggra- vated by other structural trends which have taken place since the 2008 crisis. One is the growing dominance of passive investing, which itself is linked to the emergence of high-fre- quency trading. Over the past 12 years, assets managed passively have quadrupled to $3.5trn (£2.8trn) while the major- ity of equity trades now occur electronically. For Tomlinson, the growing impact of risk parity programmes, which switch between assets based on changes in volatility, is another manifestation of these challenges. “People have pointed the finger at risk-parity programmes, which is poten- tially reasonable,” he says. “As volatility has risen, many risk-parity programmes had to deleverage, which has led to wholesale selling of pretty much every asset, creating a vicious effect. Risk-parity programmes are, of course, not the only factor in that, there are many others as well, but it is clearly the clue to deleveraging.” While these strategies offer individual investors the ability to respond to changing markets more swiftly and cost efficiently, they have increased the risk of markets moving swiftly in one direction. Put differently, what may be a rational approach from an individual investor’s perspective may not necessarily be beneficial to overall market stability, a contradiction dubbed “tragedy of the commons” by 19th century economist William Forster Lloyd.


Covid impact - strange relationships The sum of these contradictions came to play in March when the VIX rate, a volatility index based on S&P500 option pric- ing, surged to 82.9 basis points from less than 14 basis points in a single month. While sudden changes in equity markets are nothing out of the ordinary, investors became concerned as the crisis spread to other asset classes. For John Roe, head of multi-asset fund management at Legal and General Investment Management, this suggested that the global economy was on the brink of something much more serious.


Banks almost act like brokers rather than intermediaries Barry Kenneth, Pension Protection Fund


“We started seeing strange relationships, for example, when real yields on US inflation and government bonds went from -50 basis points to +60 basis points in less than two weeks,” he said. “That’s when the thing changed from being about funda- mentals to being about leverage and the unwinding of leverage and of bank balance sheets. The volatility was no longer about the virus, the concern then was that if central banks don’t step in fast and control this volatility, we are going to see the mass liquidation of assets across all markets. “There was a one week period where we felt that the Fed and other central banks should get involved fast to bring this vola- tility down, or this is going to get so far out of control that the virus is going to be an afterthought.” Roe and Kenneth identify the sudden changes in what were previously thought to be safe haven assets as indicative of structural market shortfalls. “All you have to look at is some of the things that have happened in the past four to six weeks,” Kenneth says. “If you look at things like WTI and the commod- ities market, they are trading in the negative 40s so you have to pay $40 to deliver a barrel of oil. The oil market has never traded below zero before.” While all asset classes were equally affected by the sudden surge in volatility, the contradictions were most obvious in fixed income markets. Stuart Trow, credit strategist at the Euro- pean Bank for Reconstruction and Development, recalls: “The clear divergence between investment grade and non-invest-


Issue 93 | May 2020 | portfolio institutional | 23


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