Chris Morrison, head of strategy at Omni Macro Fund, which generated 5.9% returns in August, says it is important to always consider fat-tail risks.
“We don’t want to be on the wrong side of convexity if there is a peg break, as with the SNB in January, or a spike in equity market volatility,” he says.
“It is important to know where the risks are in your portfolio. We have a positive skew between up months and down months, which for me is the best single statistic we have over our peers. It’s as much about what we choose not to do as what we choose to do.”
The Swiss peg debacle illustrates the point, says Morrison, adding: “EURCHF was at 1.20, but if you looked at what peripheral yields were doing it didn’t look right, it looked toxic.
“We could have held a long EURCHF position and might have made some money in the short term, but we didn’t want to become entangled in it as it was too big of a risk. If you want to avoid traps you have to accept you will miss opportunities.”
Morrison believes Japan and China are now in similar situations to the one Switzerland faced at the start of the year, with their central banks sustaining a substantial overvaluation.
“As the Bank of Japan keeps buying Japanese government bonds, eventually its balance sheet is going to reach 100% of GDP and it is going to have to decide if it is willing to let it go any higher. When they end the policy, what will happen?
“In China, the People’s Bank of China (PBoC) is the only seller of US dollars. When they pull that offer, there will be a big move up in USDCNY. All central banks have constraints, it’s just a question of where the limit is and can you anticipate it.”
|Outcomes are not clear, and neither are the reactions.|
People don’t know what the PBoC is going to do
Richard Benson, Millennium Global
The question is whether such a comparison will deter investors from these markets. That looks unlikely. On the contrary, since much of the hot money has been shaken out of China, there appear to be opportunities, says Richard Benson, co head of portfolio investments at Millennium Global.
“On Tuesday morning, a number of currency pairs, such as USD/SGD and USD/KRW, which are both good proxies for the China growth story, were back at the same levels they were at the day after the China revaluation,” he says.
It is a reminder that, regardless of market volatility, managers should focus on valuations.
“If valuations look extreme, we don’t want to be there – either long if the valuation is high, or short if it is low,” says Omni’s Morrison. “We are not trading momentum. The valuation and the fundamentals need to be right.”
For example, Omni played the oil price theme by selling CAD and buying INR, but took profits after a substantial adjustment of that exchange rate, which took the prices away from valuations it was comfortable with.
“Timing is always difficult,” says Morrison. “For us, it is about keeping the fundamentals on our side, looking for the catalysts and timing it to within six months.”
Still, there is a mood of caution among many investors.
Millennium’s Benson says: “Outcomes are not clear, and neither are the reactions,” he says. “People don’t know what the PBoC is going to do, and they don't know what the market reaction to any PBoC action would be. So this is leading to position squaring [closing out positions], and that creates opportunities.”
The number of potential pitfalls is endless, and not confined to changes in central bank policy.
Neil Staines, head of trading at ECU Group, a privately owned asset manager, says: “One risk the market does not seem to be anticipating is the potential for a sharp rise in inflation going forward in places like the US and UK, which does seem to me a reasonable possibility.”
Aside from macro calls, fund managers are mulling trading strategies that can be easily unwound.
Morrison says: “In the S&P 500 for the past two to three years, there has been a very large skew in the volatility of puts over calls.”
This suggests traders are more concerned about their ability to exit positions than about entering them. It “tells you a lot about downside risk and how unbalanced the market is”, adds Morrison.
Andreas König, head of currencies at Pioneer Investments, welcomes the current choppiness in the FX markets and the opportunities it brings. He argues there is a limit to how much time managers should devote trying to guess what the future will look like.
“Fat-tail risks are almost by definition unknowable,” he says. “It is certainly a good idea to do ‘what if’ analysis, risk manage your positions and assess how your portfolio will look if everything goes against you.
“If the losses are too big, you might want to reduce some positions or tighten some stop losses. But constantly assuming the worst-case scenario is not helpful.”
König says traders must not change their investment strategy because of market choppiness, but should have the courage of their convictions.
“An investment strategy should be robust enough to work in both low- and high-volatility environments,” he says. “You might change your approach depending on whether the market was trending or ranging, or risk on or risk off, but not because of an increase in volatility.”
However, it does argue for a rigorous approach to risk management.
Benson argues managers must understand their positions to have effective stop losses, adding: “USD/SGD is a clean trade because the markets are always open, but USD/BRL only trades nine hours a day.
“The market can open a long way from where it closed the previous session, so stop losses are not as effective. It’s important to bear these things in mind and ensure the risk-reward makes sense.”
Pioneer’s König adds: “When markets are volatile, risk can be managed with smaller positions and tighter stop losses, and the use of options instead of forwards. Correlation often increases in this environment so it makes sense to trade the major currencies, where there is more liquidity.
“And if your conviction about the market direction is lower, it makes sense to put on more relative value trades.”
Pioneer has hard stop losses and trailing-stops to take profits, which are set at the outset of a trade. That means if a position loses a certain amount, it is closed out, but if it makes money, it is left to run, and closed out at the predetermined take-profit level when it comes back.
ECU has a different approach. “We have a core position and if the market moves with us we can increase it, with tighter risk management on the additional position,” says Staines. “It’s a short-term position on top of a longer-term view. Risk management is key in markets like this.”
Other funds have a different trading style that itself mitigates some of the risks associated with heightened market volatility.
Da Vinci Invest, for example, is a macro fund that analyses news flow and looks for discrepancies in market prices. These discrepancies do not last for long, so the fund typically only holds its positions for a matter of minutes, selling out as soon as prices move to reflect the new information available.
Hendrik Klein, CEO at Da Vinci Invest, says: “In the listed futures market, all the liquidity is in one place and it is impossible to compete with the big players who trade in nanoseconds. In FX there are so many different platforms, it creates more opportunities for smaller players.”