Last month, in our February 2023 Update, “Sharpe World is Nefarious”, we posed this question:
“If a bank loses money in accrual books and can continue to fund the losses with government guaranteed deposit support, does it make a sound?
https://convex-strategies.com/2023/03/16/risk-update-february-2023-sharpe-world-is-nefarious/
Apparently, the answer is yes. Eventually.
Way back in our August 2021 Update, “Self-Organised Criticality”, we laid out how we saw “solvency” as the core fragility of the system and how, much like with the assurances of the “well trained and equipped Afghan National Security forces”, assertions would be made as to the safety of the financial system once, inevitably, the indefinite intervention came to an end. We put it this way:
“At some point, you wonder if the bubbling water will become more convincing than the previous 30-year average when the water didn’t boil? Are they blind to it? Or, as we suspect, are they just even more concerned about the, not to be mentioned, structural fragility of the sandpile? At what point, ala President Biden and his (misplaced) talking up of the capabilities of the Afghan National Security Forces, should we start to expect assurances that, even should the Fed withdraw their unprecedented monetary support, the market will be able to stand up to the pesky residual solvency fingers of instability? Of course, to some extent, we hear this all the time. We hear how, under Basel III, the banks are stronger and better capitalized than ever! Surely, they don’t need central banks to underwrite the values of the assets that they own. We hear of innovative new life rafts like the Standing Repo Facility that will smooth market function when central banks aren’t around to buy assets from over-levered holders. We hear of permanent standing swap-lines around the world. We hear of central clearing, new more sophisticated margining protocols, more and more reams of regulatory reporting and oversight. The financial system is well trained and well equipped to stand up against any of those un-surrendered solvency issues that may have survived the years of artificial support. Keep your ears open.”
https://convex-strategies.com/2021/09/22/risk-update-august-2021/
Well, it turns out that heavily regulated, professionally audited, publicly listed, “well capitalized” banks can still become insolvent. As ever, following the famed Hemingway quote, it happened “gradually and then suddenly”. We saw the demise of two significant banking institutions in March (and a couple of less relevant smaller ones).
Silicon Valley Bank (SVB) in the US was taken over by the FDIC on March 10th. This, from CNBC, is a common headline on the day:
“Silicon Valley Bank is shut down by regulators in biggest bank failure since global financial crisis”
Anybody can go and review SVB’s regulatory filings. On February 27, 2023, they filed their Basel Pillar III Standardized Approach Disclosures for year-end 2022: circa 10 days before being taken over by the FDIC. It is worth taking a look at this report. The beauty of SVB is that it has one of the simplest bank balance sheets you will ever see. It is, in essence, just deposits on one side, with loans and securities on the other side.
Nothing could be simpler. By all measures they weren’t just well capitalized, they were significantly over-capitalized! At least relative to the regulatory minimums.
Figure 1: SVB Financial (the Holding Co.) and SVB Bank Regulatory Capital Ratios. Dec 31, 2022
Source: SVB Basel Pillar III Disclosures.
As of year-end, they were well above a particularly important threshold, the “Capital Conservation Buffer”. As noted in the report:
“To avoid restrictions on capital distributions, such as dividends and equity repurchases and certain discretionary bonuses payments, SVB Financial and the Bank are required to maintain a Capital Conservation Buffer of at least 2.5%….There were no limitations of SVB Financial’s and the Bank’s distribution and discretionary bonus payments resulting from the capital conservation buffer framework as of December 31, 2022.”
I’m sure management was very happy about that.
There is another table in this filing that we want to draw attention to.
Figure 2: SVB Financial and SVB Bank Capital Adequacy. Dec 31, 2022
Source: SVB Basel Pillar III Disclosures
It is easy enough to see in this table how they have calculated the three Capital Ratios that we noted above in terms of their regulatory requirement, ie they are dividing the different Tiers of Capital by the Risk-weighted assets (RWAs). There are, however, two other rows in this table that, basically, appear nowhere else and get no additional discussion in the report. Those are “Average assets” and Tier 1 Leverage Ratio”. This, as they say, is where the rubber meets the road.
Their actual, aka “average”, assets are a cool $100bio larger than their regulatory measured Risk-weighted assets. From a regulatory perspective, they don’t hold capital against the risk of these assets. We can simplify it and say that they have the equivalent of $100bio of 0% RWA, something like US Treasury bonds. Digging deeper, including following references to their 10-K filing, we can see that the bulk of these US public securities fall in a > 5yr bucket. As a simple proxy for that we can use the Bloomberg US Treasury Total Return Index to see how that has worked out since their last full year reporting period in 2021.
Figure 3: Bloomberg US Treasury Total Return Index. Normalized to 1 Jan, 2022
Source: Bloomberg
It is not all that clear in the official filings, but we now know that the bulk of these securities were held in non-Mark-to-Market, Hold-to-Maturity (HTM) accounts. In other words, accrual accounting. Per the above chart we can surmise that if they did have $100bio of HTM bonds with a similar maturity to our index, and there were no offsetting hedges, the market price of the bonds would in theory be down 13% from the 2021 year-end valuation. That very oversimplified calculation means that, at then current market value, they would have wiped out circa 100% of CET1 Capital, not to mention all of their Capital Conservation Buffer, and then some.
Of course, none of this warrants any mention whatsoever in either their regulatory or public listing official filings. They were, by the accounts of all their overseers, very appropriately following the strictly imposed Sharpe World requirements.
Their disclosures go into all the usual detail about how well managed and disciplined their activities are, touch on all the necessary issues and complexities of the various risks that they undertake. In the 10-K there is a whole section, that gets referred to in the Basel Pillar III Disclosure, on Interest Rate Risk Management (Item 7A of SVBFG’s 2022 Form 10-K).
Reading 10-K filings is not something that we recommend. If, however, you are keen to see just how obfuscation gets done in the world of banking, have a crack at it! As we said above, SVB is a wonderfully simplistic bank to cut your teeth on.
The next victim of the withering sandpile is not a simplistic bank. Credit Suisse (CS) is one of the roughly 30 banks in the world that is designated as a Globally Systemically Important Bank (G-SIB). The latest update from the Financial Stability Board (FSB) came out in November 2022.
https://www.fsb.org/wp-content/uploads/P211122.pdf
As it notes in the FSB updated listing, the following requirements are applied to G-SIBs:
- Higher Capital Buffers.
- Total Loss-Absorbing Capacity (TLAC).
- Resolvability.
- Higher supervisory expectations.
Despite the global standard of higher levels of oversight, Credit Suisse was on the verge of bankruptcy and, on March 19th, was shoe-horned into an emergency buyout by their fellow Swiss based G-SIB, UBS.
As must be the case, particularly for a bank with the added level of scrutiny that a G-SIB is under, we can easily review CS’s Basel Pillar III Regulatory Disclosure for year-end 2022. This one is much more complicated in terms of what is hidden behind the numbers. On the face of it, however, it comes down to the same façade. By all metrics, CS is very well capitalized.
Figure 4: Credit Suisse RWAs and Capital. Basel Pillar III Regulatory Disclosure. Dec 31, 2022
Source: Credit Suisse website
Once again, on the surface, they appear very well capitalized! Well above their simple 8% regulatory threshold (before G-SIB buffer requirements). CHF 50bn of CET1 capital against a mere CHF 250bn of RWAs. 19.9% of eligible capital. And yet:
Figure 5: Credit Suisse Share Price (white) and 5yr CDS (blue-inverted). Mar 2021 to Mar 17, 2023
Source: Bloomberg, Convex Strategies
By Monday morning, March 20th, 2023, the Swiss authorities had orchestrated a take-over of CS by UBS. UBS paid roughly CHF 3bn, circa 60% below the Friday closing valuation, and were gifted with a CHF 16bn write-off of AT1 bonds, as well as a CHF 9bn loss assumption by the Swiss government. The SNB offered up CHF 100bn in additional funding, on top of the CHF 54bn it had provided to CS the previous week, to shore up the merging institutions.
https://www.reuters.com/business/finance/ubs-take-over-credit-suisse-central-bank-2023-03-19/
Where did all that capital buffer go?
Again, we can garner some knowledge from their regulatory disclosures. The below table shows something cleverly labelled “Leverage ratio denominator”. This, again, is the total assets of the bank, as opposed to RWAs (although in a G-SIB even this number is heavily modelled). We leave it to readers to come up with their own reasoning as to why they assign it this misleading title. This time actual assets exceed RWAs by a whopping CHF 400bn. Turns out the 19.9% capital buffer might just be overstating things a smidge.
Figure 6: Credit Suisse Gross Balance Sheet. Basel Pillar III Regulatory Disclosure. Dec 31, 2022
Source: Credit Suisse website
It would take a PhD in Sharpe World regulatory risk and accounting techniques to truly dig into and understand the reporting by CS. Our opinion is that it is obfuscation in the extreme and, precisely similar to SVB, it is all perfectly within the rules. Don’t let the appeasers fool you, the only thing different about CS and SVB with the rest of the global banking system is in level of severity. They are all following the same rules – Sharpe World rules.
We aren’t the only folks regularly harping on about this. Former Kansas City Fed President and FDIC Vice Chair, Thomas Hoenig, has long been beating the same drum. He lays it out very clearly in this recent note, “Bank Leverage, Regulatory Capital, and the Illusion of Safety”.
“The market no longer determines what is adequate capital for the banking industry. Following generations of taxpayer support and government involvement, politicians, regulators, and lobbyists have supplanted the market in determining what counts as capital, how it is calculated, and how much is enough. This artificial mechanism has resulted in a decline of both the level and quality of capital among the world’s largest banks.”
And then again in a short note specifically focused on SVB, “SVB, The Blame Game Begins”.
https://medium.com/@thomas.hoenig39/svb-the-blame-game-begins-533bd447a9d3
“The regulatory authorities need to stop pretending that their complex and confusing capital models work; they don’t.”
Touché.
Our friend Charles Goodhart, along with Jon Danielsson, also chimed in on the topic, penning a nice piece on the circumstances that led to the demise of SVB and CS. They point out the impossible trilemma of trying to 1) sustain economic growth, 2) keep inflation close to the 2% target, and 3) maintain financial stability. The note gets, in a very matter-of-fact way, into the sandpile nature of this trilemma.
“Lax monetary policy, designed to help the economy grow, made the financial system dependent on low interest rates. Banks adapting their operations to the low interest rate environment was not seen as a problem because they would only face difficultly if rates were to rise. Consequently, a necessary condition for that monetary policy to be sensible is that inflation would never rise.”
Charles and Jon have restated our standard rebukes for the extreme monetary policy measures of our modern-day central banking friends; “What if it works?” (https://convex-strategies.com/2021/03/17/risk-update-february-2021/) “How did they expect it would end up?” (https://convex-strategies.com/2022/05/19/risk-update-april-2022/)
If you believe the official public statements of those that sat atop the hierarchy of overseers, they saw nothing of the sort. The article quotes then Governor of Bank of England (BOE) and head of the Financial Stability Board (FSB), Mark Carney, thusly: “[o]ver the past decade, G20 financial reforms have fixed the fault lines that caused the global financial crisis.”
This quote relates to Mr. Carney’s July 2017 letter to the G-20 in his role as Chairman of the FSB. It is a fantastic read as a reminder of what they would like us to believe. (please see last month’s Update for a discussion on how central banker’s see their role as communicators – https://convex-strategies.com/2023/03/16/risk-update-february-2023-sharpe-world-is-nefarious/).
https://www.fsb.org/wp-content/uploads/P030717-1.pdf
A short listing of quality statements from the FSB Chairman to the G-20 includes:
- “The largest banks are required to have as much as ten times more of the highest quality capital than before the crisis and are subject to greater market discipline as a consequence of globally-agreed standards to resolve too-big-to-fail entities.”
- “A decade ago, enormous risks were built up outside the core banking system and away from effective supervision with devastating impact on the real economy.” (our note, have to love the claim that there was “effective supervision” of the core banking system pre-GFC) “A decade on, as a result of these measures, the financial stability risks from the toxic forms of shadow banking at the heart of the crisis no longer represent a global stability risk.”
- “A decade ago, OTC derivatives trades were largely unregulated, unreported and bilaterally cleared…….a decade on, meaningful progress has been made towards mitigating systemic risk as a result of progress in trade reporting, central clearing frameworks, and new capital and margin requirements.”
- “The Basel Committee has agreed many of the final elements of the Basel III package, which will include revisions to the risk-weighted asset framework and the finalisation of the international leverage ratio standard.”
- “The FSB’s misconduct work plan delivered to this Summit outlines measures to restore public trust in the financial sector, including through a greater emphasis on individual accountability.”
A well trained and well equipped Afghan National Security force, indeed.
One wonders if the proponents of these policies and standards will ever have to face their own emphasis on individual accountability. Interestingly, Mr. Carney stresses the importance of standardization and harmonization, while in the above note from Mssrs. Goodhart and Danielsson, they propose just the opposite. As one of their solutions, they propose to “make the institutions of the financial system more heterogeneous or diverse.” As usual, we would lean towards Mr. Goodhart.
To our view, this comes down to the same old premise, it is all about skin-in-the-game. For years we have given presentation after presentation that close with these two slides:
- Question: What is the Key to Risk Management?
- Answer: Accountability.
Charles and Jon make this point in their above note, pointing out that financial authorities face two key problems.
“The first is that the financial system is, in effect, infinitely complex, and even if the authorities successfully identify a lot of risk and areas where it is taken, there is an infinite scope for risk to emerge elsewhere. There is no way to identify and manage all of that risk effectively.”
“The second problem is that, in general, financial risk cannot be properly measured.”
Under this dilemma, those without skin-in-the-game settle on “probabilities” as the core solution to the problem. This is Sharpe World. In the real world, real people with skin-in-the-game address these challenges through considering “possibilities”. This is how we create something that has never existed before or avoid the catastrophic event that has never before occurred.
Our dear friend, Dr. Pippa Malmgren, drafted a recent note on Artificial Intelligence (AI) and, as she tends to do, laid bare this very point, just far more poetically than we ever could.
https://drpippa.substack.com/p/pippa-passes-wet-brains-vs-dry-ai?sd=pf
Her oh so clever “dry (AI) vs wet (brains)” is the parallel of our “probability vs possibility”.
“Number crunching is linear. It gets you certain kinds of answers based on specific inputs. Answers to specific problems are linear. Novelty is lateral. Humans have the ability to make enormous leaps in their thought processes and perspective. That’s how humans break the rules to produce new theories, new stories, new ideas, new songs, new poetry, new brands, new businesses, and new love stories. AI follows its rules allowing it to generate results that we may admire but which are merely a perfection of inputs and linear processes. The problem is that we humans love being rational, predictable, and goal-oriented. We think we can optimize life. But, we can’t. The detours in life and the failures are part of the optimization process. It’s what we learn in the dark shadows of a seeming wrong turn that illuminates where life’s true North lies.”
She could be writing about the evolutionary process of punctuated equilibria! She takes a further step straight into the concept of Per Bak’s “critical state”.
“The orderly in this world want and need the surprise of some chaos, and the chaotic want and need the pleasures of order. Humans live and create from the act of balancing between the polarity of these forces.”
Per Bak puts it this way in “How Nature Works”:
“A frozen state cannot evolve. A chaotic state cannot remember the past. This leaves the critical state as the only alternative.”
Like us, many of you, upon perusing Pippa’s note, likely found your minds snapping to the works of famed (?) English economist GLS Shackle. Our own concept of “probability vs possibility” really originates from Mr. Shackle. Nassim Taleb, in “The Black Swan”, extols Shackle, along with Hayek and Keynes, as “one of the rare celebrated members of his ‘profession’ to focus on true uncertainty, on the limitations of knowledge, on the unread books…..” Nassim goes further and credits Shackle with introducing “the notion of ‘unknowledge’….”
For a simple introduction to Shackle we link here a note that he wrote, “The Student’s Pilgrimage”, on his own evolution of thought. We highly recommend clicking in and reading this short 10-pager (we might further suggest contemplating Shackle’s note in parallel to the Brian Arthur note, “Economics in Nouns and Verbs”, that we linked to in last month’s Update).
https://rosa.uniroma1.it/rosa04/psl_quarterly_review/article/view/10772/10651
“Uncertainty, unknowledge, is what confronts the chooser of action when his act of choice is going to be an experiment the making of which will destroy the possibility of ever making that experiment again. In such a case we cannot say what will happen, even if we only claim to it half-heartedly, as a ‘probability’. We can only attain some notion of the kinds of thing that can happen.”
So many of the things that Sharpe World disregards. Shannon’s Entropy. Ergodicity. Time. Skin-in-the-game. Choice. All in one simple paragraph.
Shackle takes our concept of ‘possibilities’ to the next level and upgrades the texture of it to ‘imagination’ – “a word which has become the central term of my conception of the business of choice, a business which, as I have become profoundly convinced, is in the first place a work of imaginations. The choosables must be imagined, originated, created, by the chooser himself.”
Here, again, we find Pippa’s ‘wet brain’.
To anybody not impeded by Sharpe World goggles, it is easy to visualize the difference between the probabilistic predictors versus the real world, skin-in-the-game, imaginers. We can go back to this wonderful image that came to us via the ECB’s Isabel Schnabel that we shared in our December 2022 Update (https://convex-strategies.com/2023/01/17/risk-update-december-2022-restoring-market-function/).
Figure 7: Eurozone 3yr Ahead Inflation Expectations: Professionals vs Consumers
Source: ECB Speeches of the Board Members. Convex Strategies.
The Survey of Professional Forecasters, the probabilistic predictors, organize around a slowly adapting Normal/Gaussian distribution, the chart on the left. They have no skin-in-the-game and suffer no consequences of their failed forecasts. The Consumer Expectation chart on the right, on the other hand, represents our concept of possibility and is heavily skewed by the real-world nature of having skin-in-the-game. Consumers suffer the true harm/opportunity of the possible and see the only truly relevant outcomes as those that would result in uncertainty, entropy, chaos. Frequency matters little. Magnitude matters a lot.
As Nassim so aptly states it in this clip, right at the 6:00 mark: “Economists have been giving us bullshit models for a long time now. Why? Because they are never harmed by their mistakes, we are harmed.” In Sharpe World, without accountability, there is no learning.
We cannot resist but to, yet again, quote and link to Hayek’s fantastic Nobel Prize Lecture, “The Pretence of Knowledge”.
https://www.nobelprize.org/prizes/economic-sciences/1974/hayek/lecture/
“And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement……I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false.”
While on the topic of uncertainty, we would be remiss to not also mention American economist Frank Knight and what has come to be known as Knightian Uncertainty. Knight’s thesis is laid out in his excellent work, “Risk, Uncertainty, and Profit”.
https://oll.libertyfund.org/title/knight-risk-uncertainty-and-profit
“But Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk”, as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their casual relations to the phenomena of economic organization, are categorically different….The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. There are other ambiguities in the term “risk” as well, which will be pointed out; but this is the most important. It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”
This tracks remarkably well with conversations we find ourselves engaged in regularly. Those go along the lines of an investment manager asking how we could possibly know what their portfolio risks are, those which they may desire aid in mitigating? Generally, they are of the opinion that their risks are defined by a particular asset class and/or a particular geographic market (eg. S&P Beta). Our answer is most always that their risks are correlation and volatility. When they push back and ask how can we know that, we simply give them the Knightian answer that they measure their S&P Beta risk, making it “not in effect an uncertainty at all”. Then, in the normal course of the discussion, they ponder the elephant sized idea bubble as to the realization that they are unaware, in any way whatsoever, as to their exposure to correlation and volatility.
The same, naturally, goes for economics. As we discussed last month per the Brian Arthur note, the mathematical form of economics, as it is generally practiced, lacks verbs. Knight stresses the same: “We have no way of discussing a force or change except to describe its effects or results under given conditions.” In a self-organized, or complex-adaptive, system, this misses the whole point of how the real world works. It does, ever so clearly, describe how modern-day central bankers function. As Knight describes the static method of economics: “We must first discuss one change at a time, assuming the others suspended while that one is working itself out to its final results…”
In Knights version, our “possibility”, Shackles “imagination”, Pippa’s “wet brain”, becomes “thought”. Our “probability vs possibility” is Knight’s “analysis vs thought”.
Should you be curious to see another shining example of the lack of “thought”, we give you a recent speech from Bank of England Governor, Andrew Bailey.
We have mocked many a central banker’s speech but this one manages to really standout and the best that we can say about it is that it lacks any of Shackle’s “imagination”.
It follows the standard form of explaining away the present state of affairs as being the result of unforeseeable exogenous events. In this case, Brexit-Covid-Ukraine. He even goes so far as to refer to it as the “inflation that has come to us from abroad”. Despite stating that “Monetary policy exerts a powerful influence on the components of aggregate demand…”, apparently the last decade and a half of the most extremely stimulative monetary policy in the long long history of the BOE had no impact, whatsoever, on the inflationary spiral they find themselves in today. It is a far too common tune with this crowd.
Figure 8: UK CPI yoy% (white). BOE Bank Rate (blue). BOE Balance Sheet/GDP (orange)
Source: Bloomberg, Convex Strategies
We are meant to believe that the lowest policy rate ever in history, lower than BOE held it through the Great Depression and WWII, along with an unprecedented balance sheet expansion, had nothing to do with the pickup in inflation. Yet, they assure us that these are the very tools that they alone are tasked with wielding to control inflation. How stupid are we assumed to be?
Mr. Bailey stresses throughout the speech that, while all of the circumstances leading to the current out-of-mandate inflationary episode are not related to their past or present policy settings, they will, through utilizing the very same tools, see that their measure of inflation returns to their mandated 2% target.
Mr. Bailey has now had to draft his explanatory letter, as to failing to maintain price stability below BOE’s mandate, to the Chancellor for 7 consecutive quarters. The most recent one is just as nonsensical as the previous 6.
You would be forgiven for doubting his sense of urgency as he continues to run a historically extreme negative real policy rate.
Figure 9: BOE Bank Rate (white) and UK CPI yoy% (orange). “Real Policy Rate” (lower panel)
Source: Bloomberg, Convex Strategies
As we discussed last month, we can’t help but think that Mr. Bailey is making every effort to communicate. At least some portion of what he communicated in this speech came across with this headline in the Telegraph.
“Early retirement has forced up inflation, says Andrew Bailey”.
He won’t say it, but we can safely surmise that he thinks the sandpile is too fragile. As we have discussed at length, who is going to own the 40? Sharpe World has conspired to incentivize fiduciaries to load up, with other people’s capital, on government debt. US Treasury bonds are treated as 0% RWAs on bank balance sheets. Levered UK Gilt exposures are deemed as “hedges” in Liability Driven Investment (LDI) schemes. The 40 in 60/40 is deemed risk reducing. The Sharpe World driven holdings of debt is mission-critical to the sustainability of a world of 360% debt/gdp.
“They” can’t let the capital flee Sharpe World and watch as borrowing costs adjust to a price determined by the actual end capital owners. So, they buy Gilts to save the LDI pension schemes. They construct Transmission Protection Instruments (TPI) to buy bonds even as they undertake policy tightening. They innovate Funds-Supplying Operations against Pooled Collateral to encourage banks to buy more bonds. They invent a Bank Term Funding Program (BTFP) to prevent banks from liquidating duration assets with unrecognized losses. As we have been actively discussing since our September 2022 Update, “Is Sharpe World Closing?” (https://convex-strategies.com/2022/10/18/risk-update-september-2022-is-sharpe-world-closing/), they move ever closer to “closing the gates”.
Can they thread the needle and restore price stability without collapsing the sandpile? Will they forego their mandates to maintain price stability to focus on the fragility of the sandpile? Or will they go strong after the spiralling inflation to try to recapture some credibility only to see one avalanche of wrongly regulated entity after the next tumble into the pit of insolvency? We don’t know!
What we do know is that convexity is the answer to the challenge of compounding returns. That challenge likely gets even greater, particularly for Sharpe World practitioners, if the world transitions out of the recent era of unprecedentedly low volatility of price stability measures.
Figure 10: Eight Hundred Years of Inflation in the UK, 1217 to 2016. Revised with 2017-2022
Source: https://personal.lse.ac.uk/reisr/papers/22-whypi.pdf /Millenium dataset of the Bank of England. Convex Strategies.
What is a return to normalcy in the above chart? Is it going back down to the level of volatility seen in the 1997-2016 dot? Is it converging gently back to an average of 2%? We doubt it. More likely, the return to normalcy entails going back toward historical norms of much higher levels of volatility for price stability measures. It likely means seeing averages that significantly diverge from the 2% target, in both directions.
We showed last month how various hypothetical convex portfolios would have outperformed traditional Sharpe World strategies throughout the period of constrained volatility, and then even more so since leaving that regime behind. We can zoom in, just since the regime shift from 2020 onwards, and look at the impact that the hypothetical convexity could have made.
Using the traditional Balanced Portfolio 60/40 (in this example, 60% in SPX Total Return Index {SPXT Index} and 40% in Bloomberg US Treasury Total Return Index {LUATTRUU Index}) we can construct a hypothetical Barbell Portfolio by taking the 40% in bonds and splitting it equally between Long Vol (in this example, the CBOE Eurekahedge Long Volatility Index – an index of active long volatility managers {EHFI451 Index}) and more equity exposure. A simple scattergram and compounding view of the performance of a hypothetical 50/50 of SPXT/LongVol versus US Treasuries since the beginning of 2020 gives a clear indication as to which one makes a better portfolio companion to the rest of the equity in a portfolio.
Figure 11: 50% SPXT/50% LongVol vs 100% US Treasury. Scattergram and Return Distribution. Jan2020-March2023
50% SPXT/50% LongVol vs 100% US Treasury. Compounding View. Jan2020-March2023
50% SPXT/50% LongVol vs 100% US Treasury. Ratio of NAVs. Jan2020-March2023
Source: Bloomberg, Convex Strategies
The hypothetical package of LongVol and more beta has visibly more convexity than the US Treasuries on their own. It protects more. It participates more. It has a lower Max Drawdown (6.0% vs 17.8%). It has lower Downside Volatility (2.5% vs 3.5%).
Any regular readers should know what comes next. Given the efficiency of the LongVol exposure (ie. more return for less risk), lever it 2x. So now, on a standalone basis, our convex alternative becomes SPXT 50% and LongVol 100% (50% 2x levered) versus our starting point of 100% in US Treasuries.
Figure 12: 50% SPXT/100% LongVol vs 100% US Treasury. Scattergram and Return Distribution. Jan2020-March2023
50% SPXT/100% LongVol vs 100% US Treasury. Compounding View. Jan2020-March2023
50% SPXT/100% LongVol vs 100% US Treasury. Ratio of NAVs. Jan2020-March2023
Source: Bloomberg, Convex Strategies
More convexity would seem to lead to more protection and in turn more compounding.
It is simple enough from there to bundle everything back together and hypothetically compare the starting point of 60/40 with the convexity improved version that replaces the 40% with the combination of explicit protection and more participating risk. Given the far greater risk mitigating dynamics, as regular readers are familiar, we can add some higher-octane participation to the barbell strategy, for simplicity we like to use Nasdaq100 Total Return Index (XNDX) as a proxy for that added upside participation. That gets us to what we have dubbed our Always Good Weather (AGW) portfolio, a hypothetical construction of 40% SPXT, 40% XNDX, and 40% CBOE Long Vol Index.
Figure 13: AGW (40/40/40) vs Balanced (60/40). Scattergram and Return Distribution. Jan2020-March2023
AGW (40/40/40) vs Balanced (60/40). Compounding View. Jan2020-March2023
AGW (40/40/40) vs Balanced (60/40). Ratio of NAVs. Jan2020-March2023
Source: Bloomberg, Convex Strategies
Some might claim that we have cherry-picked the period by isolating the new higher inflation-volatility regime and you would be, in a sense, correct. The relative compounding performance of the superior convexity portfolio does shine brightest during the more uncertain world. There is, however, another very important contributor to compounding. That would be time.
The sooner you improve convexity, the sooner you improve compounding we believe.
Figure 14: AGW (40/40/40) vs Balanced (60/40). Scattergram and Return Distribution. Jan2005-March2023
AGW (40/40/40) vs Balanced (60/40). Compounding View. Jan2005-March2023
AGW (40/40/40) vs Balanced (60/40). Ratio of NAVs. Jan2005-March2023
Source: Bloomberg, Convex Strategies
All hypothetical of course, but a pretty good example of what could have been more return (CAGR of 12.1% vs 7.1%) on less risk (Max DD and Downside Vol of 25.1% and 6.1% vs 28.2% and 6.8%). Convexity would appear to equate to positively skewed returns and lead to superior terminal capital outcomes (799 vs 350, circa 2.3x).
We firmly believe that uncertainty will be the driver of investment performance. Our analysis definitively indicates that to be the case over recent decades, even during a period of historically anomalous inflation mean and standard deviation. Away from that anomaly, we would imagine it will become even more relevant.
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