Beware of The New Systemic Risk

Includes: DIA, QQQ, SPY
by: AllianceBernstein (AB)

By Ashwin Alankar and Michael DePalma

It felt like there was nowhere to hide from the market declines last Monday, April 15, when stocks, bonds and commodities fell in unison across the world, well before the Boston bombings that day. We believe that this failure of diversification was instigated by increasingly powerful multi-asset funds, many of which use leverage, which may have become a new source of systemic risk for investors.

Investors have struggled to pinpoint the epicenter of last week’s market convulsions. Some say central bank gold sales started the chaos. Others blame weak economic data in China and the U.S., or fears that the Fed’s quantitative-easing policies may soon end. But these theories don’t explain why most asset classes sold off so sharply (Chart), with even the safest assets, such as Treasuries, offering little protection. In this environment of sharply correlated declines, investors were extremely vulnerable to tail risk—the risk of larger-than-estimated losses—and the disappearance of diversification.

Sound familiar? Rewind to early August 2007, when hedge-fund strategies plunged simultaneously. The trigger for that “quant crisis” was extreme losses suffered by multi-strategy hedge funds in their asset-backed sub prime mortgage positions and the subsequent margin calls.

At the time, after a seven-year stretch of solid performance, no single hedge-fund strategy or genre had the capacity to absorb ongoing large inflows. To expand their reach, multi-strategy hedge funds emerged, investing in everything from fundamentally driven merger and acquisition strategies to quantitatively driven long/short equity strategies. As a group, these funds became more powerful than anyone realized—and more vulnerable. With so many strategies under the same roof, seemingly unrelated strategies became correlated, because they were all exposed via liquidation-driven derisking.

We think a similar scenario played out last week, this time with multi-asset-class funds. In the aftermath of the global financial crisis, multi-asset funds, including mutual and hedge funds, became much bigger players as investors sought new ways to diversify exposure to systemic market risks. Global assets in these strategies have increased by 76%, to U.S.$3.1 trillion, since 2008 (Chart). Since these strategies invest across asset classes and are often highly leveraged, losses in one asset class can force a broad sell-off in order for a manager to meet margin calls or maintain diversification. Such a loss can also have a domino effect, when pressure at one leveraged multi-asset fund causes others to feel the squeeze.

Of course, multi-asset funds serve an important diversifying role for investors, by sourcing returns across the markets. However, we think that the sheer size of these strategies—especially leveraged ones—has created a new systemic risk that investors cannot afford to ignore. In our view, the proliferation of these funds means that correlated risk-off episodes such as the 2007 crisis and the events of last Monday are likely to become more common.

So what can investors do? First, risk management frameworks can be retooled to focus more on tail risk and stress-testing amid correlation spikes. By understanding how asset classes behave under extreme pressure, better defenses can be built for abnormal market events.

Although no portfolio or allocation can be completely shielded from absolute declines during such events, there are ways to mitigate the damage. Diversifying exposure to tail loss can also position a portfolio to avoid paying painful adjustment costs such as the additional underperformance that results from derisking, deleveraging or buying protection after the fact. It also increases a portfolio’s ability to benefit from an eventual recovery after a sharp, correlated market event. History has shown that reactive, defensive risk management often turns out to be much more expensive and less effective than proactive, offensive planning for unexpected hazards.

Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Ashwin Alankar is Senior Portfolio Manager of Quantitative Investment Strategies and Co-Chief Investment Officer of Tail Risk Parity at AllianceBernstein. Michael DePalma is Chief Investment Officer of Quantitative Investment Strategies and Co-Chief Investment Officer of Tail Risk Parity at AllianceBernstein.