Trends Watch: Risk Premia Strategies; Trade; Debt
June 06, 2019
By Elana Margulies-Snyderman
EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.
This week, Elana talks to Anthony Limbrick, Principal-Portfolio Manager, 36 South Capital Advisors.
What is your outlook for alternatives?
As a result of lower average fixed interest and deposit rates globally, the last decade has seen an increasing allocation to alternative risk premia strategies as a proxy for what used to be steady incremental investment returns that historically were more balanced against structural investment cycle risks than they are today. As part of that there has been an allocation to short volatility strategies, as well as replication of short volatility type exposures that monetize uncertainty and gap risk premia. With this large allocation to monetizing what are now very tight risk premia, we believe there is a dangerous negative asymmetry built into alternatives portfolios, combined with a lack of true diversification. That leaves those portfolios vulnerable to the emergence of a risk-off environment, which could see substantial losses appear as a result of mean reversion of risk premia.
What is your outlook for the economy?
Our outlook for the global economy has two major drivers. Firstly, and something for which it is difficult to predict the outcome, world economic growth is hostage to the trade relationship between the U.S. and China. If this were to develop into an increasingly aggressive stalemate, the outlook for global economic growth is dire. It is our view that interests are still aligned, so eventually some sort of deal will be done, but there is still a possibility it won’t, so we believe that investors should be investing accordingly i.e. using probability risk weighting in terms of their allocation to risk assets. We note world trade volumes are starting to fall. The magnitude of the fall is historically consistent with early-stage recession environments.
Secondly, debt levels globally are extremely high, and far surpass what was an extremely vulnerable financial system in 2007. That being the case, there is a latent instability present in financial markets that could manifest in extreme volatility over the next few years.
On top of this, we are seeing long dated implied volatility across asset classes at circa-2007 levels; this indicates complacency.
What keeps you up at night?
Liquidity and gap risk continue to worry us from a systemic perspective. There has been an explosion of corporate debt issuance in recent years, while at the same time the ability of the secondary markets to take large flows has more than halved in capacity. For example, if there were to be signs of a global recession, we believe debt market investors would forecast an increase in default rates, which could see large numbers of investors looking to switch into less risky exposures. If they all move at the same time, we could see major pricing discontinuities in markets. There is a similar problem with equities where recent market down-moves have betrayed an alarming lack of market depth. We believe this to be a result of a market that has really only been supported by passive fund buying and buyback activity. We believe this gap risk, which is a subset of liquidity risk, is a clear and present danger to financial markets right now. We think market participants are underestimating their vulnerability to liquidity risk.