When Volatility Spikes, Financial Things Break - The Case of UK Gilts and Pensions
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest in, how to live without worrying about it. I'm your host, David Stein. Today's episode 405. It's titled, When Volatility Rises, Financial Things Break.

Volatility measures how much a security or asset class deviates from its average. That could be the average price or it could be the average return over time. A stock or an ETF is more volatile if it experiences greater swings in price.

A stock or an ETF or an asset class is more volatile if its daily, monthly, or annual return deviates significantly from its average. It could be a very high return, could be negative returns, but it's a measure of volatility. And in finance, the statistical measure used most frequently to measure volatility is standard deviation. Standard deviation is the foundation of volatility.

Modern portfolio theory, if you've ever had a financial plan or an asset allocation plan prepared for you by a financial advisor or even using some type of online planning tool, oftentimes they'll show what's known as an efficient frontier. And they'll show different portfolio mixes that maximize the expected level of return for

for a given level of volatility, and that volatility used is the standard deviation. In a recent editorial in the Financial Times, Eric Lonergan, who is a portfolio manager and author, wrote, "'The biggest structural change in investor behavior in the last 30 years is the near universal adoption of volatility as a measure of risk.'"

When I read that editorial, I was somewhat, well, I was curious about what he meant and started researching more because I know as I've done asset allocation studies over the years, volatility was just what we used.

And as I did additional research, I found a paper from October 2017 published by Artemis Capital Management. I believe the principal author of the paper is Chris Cole, who is the founder of Artemis, and they're a firm that specializes in volatility. The paper said...

What we think we know about volatility is all wrong. Modern portfolio theory conceives volatility as an external measure of the intrinsic risk of an asset. This is a highly flawed concept, widely taught in MBA and financial engineering programs. I certainly learned it in my MBA and undergrad. Those programs and typically our understanding of volatility, as they describe, is an exogenous measure of risk. But

But Cole points out that volatility actually influences risk itself. The paper continues, portfolio theory, including modern portfolio theory, evaluates volatility the same way a sports commentator sees hits, strikeouts, or shots on goal. Namely, a statistic measuring the past outcome of a game to keep score, but existing externally from the game.

The problem is volatility isn't just keeping score, but it's massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. It would be as if the baseball score itself or the number of home runs hit started to influence how many more runs were scored or how many more home runs were hit.

Why is this the case? Well, the most prominent example right now is the UK government bond market. UK government bonds are called gilts. Last December, the yield on the 20-year UK government bond was 0.9%. In early August, the yield was 2.3%. A couple months later, the

The yield on 20-year UK government bonds is 4.9%. If you lived in the UK and invested in the Vanguard UK Long Duration Guilt Index Fund, it is down 49% year-to-date. You would have lost nearly half your money investing in what many consider safe assets, government bonds, very low likely of default.

but huge potential for losses when you see that type of rate move. For comparison, U.S. long-term bonds have lost about 30% year-to-date. Now, it wasn't just 20-year yields that increased. The 10-year government bond yield in the U.K. is 4.5%. It's up 1.4% since mid-September. And it now yields about a half percentage point more than 10-year U.S. Treasuries.

The two and five year UK government bond yields are around 4.7%, 1.6% higher than they were just a couple of weeks ago. Interest rates are going up all around the world because inflation is increasing and central banks are combating inflation by raising their policy rates. In the UK, the Bank of England's policy rate is called the bank rate. It was close

close to zero back in December 2021. Today, it's 2.25%. The Bank of England's been raising that policy rate. But that isn't what caused the most recent big jump in interest rates. That was market reaction of bond investors to the UK Chancellor's mini-budget of spending and tax cuts that were announced on September 23rd, 2022.

This announcement was sort of just dropped on the market, on politicians. There wasn't really any analysis of the impact on the UK's government budget deficit or its long-term debt. The market absolutely freaked out. The British pound sterling fell to an all-time low of 1.03 pounds per dollar. And while the market reacted, much of what was occurring was because volatility spiked.

The volatility of interest rates, clearly much more volatile. But there was also a strategy used by UK pension plans called liability-driven investment. And this was something I'm familiar with because one of my pension clients many years ago, Ball Corporation, employed something similar. And it's fairly straightforward.

It's owning long-term government bonds in order to match long-term pension obligations. And the idea is by keeping the duration or the interest rate sensitivity of the bond portfolio similar to the interest rate sensitivity of the pension obligations, because as interest rates go up, not only do bonds fall, but the

the actual value today of those future pension obligations falls off also because the pension plan can now use a higher discount rate because the plan can earn a higher return because interest rates are now higher. The idea is to keep the value of the assets, in this case, the long-term government bonds, in line with the value or the value today of the long-term pension obligation.

It turns out, though, that the UK pension plans weren't just doing that. They were actually using derivatives, including embedded leverage to enhance the return of the pension plan, to increase the return. So it wasn't a simply asset liability matching strategy. It was a strategy to generate a higher return from derivatives. And that's where pension plans got into trouble. UK pension plans have

have about one and a half trillion pounds in these LDI strategies. That's triple the amount from 10 years ago.

When you see that type of growth in a particular strategy, usually it's because there's a lot of promises there and perhaps not as great of understanding of the risk. There have been times in the past where U.S. pension plans got into trouble because Wall Street sold them some type of hedging strategy to protect them or to increase returns, and they blew up. In this case, because the move of...

The government bond yields in the UK were so much higher because these pension plans utilized derivatives. There was margin or leverage. They got a margin call. The pension plans had to come up with more collateral or cash to fund those derivatives, meaning the derivatives fell in price and the bonds fell in price and the clearing houses or the brokerages demanded more collateral.

Within a matter of hours, because the rate move was so big, the volatility had spiked, the price of bonds had fallen, and what did the pension plans have to sell in order to raise cash? Government bonds. So they started selling government bonds, which pushed down the price even more and sent interest.

interest rates skyrocketing to such a degree, and there was such a lack of liquidity in the bond market that the Bank of England stepped in on Wednesday, September 28th, to announce that they would purchase up to 65 billion pounds of long-maturity UK government bonds.

That calmed things for a bit, but then markets continued to react and interest rates continued to go up to where the Bank of England has had to announce additional provisions. Supposedly, their bond buying strategy will end on October 14th at the end of this week. We'll see.

They announced a temporary expanded collateral repo facility, essentially allowing the Bank of England to lend to pension plans in exchange for collateral, presumably government bonds. Both strategies will increase the balance sheet of the Bank of England.

They're buying more bonds, even though they're supposedly in the process of reducing their balance sheet. This is another example of central banks having to come to the rescue when something in the financial system breaks. And the impetus of that is a sudden move in interest rates, a spike in volatility, causing stress for UK pension plans.

What's interesting is the Bank of England has only bought about 5 billion pounds of the 50 or 60 billion that it said it would buy.

And again, the yields calmed for a while, but then they've spiked up. Paul Dales, who's the chief UK economist at Capital Economics, wrote about this continued high yield on UK government bonds and the fact that the market hasn't calmed. He wrote, this has made us more worried that it's more than just an isolated issue in the pension industry and instead is a result of the shift from a low interest rate environment to a high interest rate environment.

We don't know what all is driving those higher interest rates. Now it appears to be more than just pension plans, which gets to the whole point. When we see a spike in volatility, unexpected things happen. Now the UK government is supposed to provide an analysis by the end of the month of the impact of

of their new program. The program was to help households and businesses with higher energy costs. Currently, the UK total government debt is about 2.4 trillion pounds. That was at the end of 2021, about 103% of GDP. Their budget deficit last year was 8%.

of GDP. UK runs a current account deficit, which is similar to a trade deficit, which means they're importing much more than they're exporting. That has spiked to 8% of GDP, mostly due to higher energy prices. And this is all the backdrop where the Bank of England was supposedly wanting to reduce their balance sheet in order to provide more flexibility to buy bonds in the future as part of a quantitative easing program.

We'll know in the next couple of weeks after the UK government releases its medium-term fiscal plan whether yields calm down or the Bank of England will have to continue to purchase assets to calm the bond market. Before we continue, let me pause and share some words from this week's sponsors.

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At Georgetown SCS, the learning never stops, and neither do you. Write your next chapter. Be continued at scs.georgetown.edu slash podcast. Why does volatility increase? Well, first, economic policy uncertainty.

particularly what central banks are doing. Benjamin Bowler, who is a global head of equity derivatives at Bank of America, said, a lot of these other factors and factors we're going to talk about that drive volatility are icing on the cake. The cake itself is monetary policy. And by monetary policy, we're talking about central banks raising their policy rates

the bank rate in the UK, the Fed funds rate in the US, in order to influence longer-term interest rates, to dampen demand for borrowing, for a continued expansion of the money supply, dampen the demand to buy things, to slow the economy, to hopefully reduce some of the capacity constraints that are leading to higher inflation. But that economic uncertainty leads to higher volatility.

Higher volatility can be a function of herd behavior, leverage. We see this with UK pension plans. All the plans started selling bonds at the same time to raise cash for collaterals to back their derivative exposure they had. That herd behavior led to further increases in

In interest rates, increased volatility. So leverage can do it. Herd behavior can do it. The fact that, as Chris Cole pointed out, volatility is a player itself. It's not an outside observer. Many of these financial models, like the model set up to these asset liability strategies, these derivative strategies, the UK pension plan used,

How much collateral they had to put up in the first place was based on estimates of volatility, of the risk of the different asset classes. And when volatility spiked, then they had to put up more collateral and sell assets to do that. And so it was very much a feedback loop.

Another driver of volatility is high frequency trading and a lack of liquidity. When volatility spikes, in this case, we're looking at the spike in what's known as the VIX, V-I-X, which is the implied volatility that's priced into S&P 500 index options. The S&P 500 is a measure of U.S. large company stocks. When VIX spikes, liquidity is reduced.

Particularly as high-frequency trading firms pull back risk. Their willingness to buy and the price they're willing to buy at falls.

In a Financial Times piece, Robin Wigglesworth, he's a columnist, wrote, When markets are calm, trading conditions are largely fine. But when the quiet shatters, many investment funds are either compelled by nervous risk managers or automatically by algorithmic rules to sell. At the same time, market making is now virtually exclusively a game for high-frequency trading funds.

When volatility rises, HFTs guard themselves by swiftly widening the prices at which they will transact and ratcheting back the size of orders they are willing to handle.

Wigglesworth referred to a research paper by Wellington Asset Management. And in that paper, it said an imbalance has developed between the supply of and demand for liquidity. And as a result, we've seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos.

When that happens, volatility spikes. In the case of Wellington, they say they distrust situations where stability, low volatility has become the consensus because they believe that conditions are ready for a surprise. There could be a drastic change. One of the changes we've saw this year is both stocks and bonds have fallen. Many investment strategies use what's known as a role-based approach.

where the idea is to have allocations to different asset classes with similar volatility, own longer-term bonds, own stocks, own gold, and the idea under different scenarios, one asset class will do better than the other, particularly that bonds and stocks will not fall at the same time. Turns out, though, that 30% of the time, there's a high correlation between stocks and bonds.

their prices move in the same direction. Most of the time, they're not correlated. But it's at 30% of the time where there is positive correlation and their prices move together, and that can lead to unintended consequences, a spike in volatility.

The Wellington Report referred to when there's a consensus or there's stability where volatility is low. When there's low volatility, low implied volatility, there's more liquidity. And many investors, including institutional investors, have gone short volatility. And by going short volatility, there's different ways to do that. But one could sell call options on the S&P 500 and collect the premium. One can short volatility.

the VIX through futures contracts and collect a premium. And there's other ways to go about this. It can be structured through other derivative securities, could be some private security. And there's some financial reasons to do that because more investors want to hedge and protect their portfolio against losses. And as a result, the price of

of these hedging strategies, like an S&P 500 put option, is higher than what it would be based on the historical experience of the markets. In other words, the actual volatility of the S&P 500 is lower than the implied volatility priced into stocks.

And as a result, over the long term, a strategy of shorting volatility, of selling put options, of going short VIX has led to a positive return. Not a great return, but, you know, 6% to 7% type return. I was looking at some research, a chart by Ned Davis Research, and you can see that over time, most of the time, implied volatility is higher than historic volatility.

When implied volatility is meaningfully higher than the actual volatility that occurs, a strategy of shorting VIX, shorting volatility is returned 30% per year, 17.4% of the time it did that.

When they were fairly close to each other or implied volatility was a little higher than actual volatility, a strategy of shorting VIX or of writing put options would have returned about 9.6% per year, close to 10%. When it's in the close range, that's about 17% of the time. But here's the kicker. The other 17% of the time realized volatility is higher than implied volatility.

And that strategy would have wiped you out had you shorted VIX. Had you gone long VIX in that scenario, the gains would have been 120% per year. If you're on the other side, you can't lose 120%. You can only lose 100%. And that happened back in February 2018, where in one day, VIX, this measure of the volatility of the S&P 500 has

as reflected in options prices, soared 116% in one day. And a number of exchange-traded products that tracked that strategy shut down because they lost 97% of the money. Now, there's been other times when VIX has moved 50% in the day. In fact, it happens every two to three years. But a 100% move is quite rare, and it was enough to knock out a number of exchanges.

exchange-traded products. When you're short volatility, Artemis points out that you're exposed to a number of risks. One is that volatility increases.

A rise in interest rates can harm that strategy. Or if the expectations with how correlated different asset classes are, if that shifts, that can harm that strategy. And then there's something that's a little more complicated called gamma risk. Gamma represents how the relationship between the price of a derivative, such as a put option, and risk

The security is based on how the rate of change between that relationship can change. I like the example that Artemis gave. They said, if you imagine you are balancing a tall ruler vertically on your palm, as the ruler tilts in any one direction, you must overcompensate in the same direction to keep the ruler balanced. And they said, conceptually, that's the same as trying to hedge an option that has high gamma risk. As prices move,

In order to hedge, it requires putting additional hedges in place. And that action can lead to higher volatility. It can move the underlying prices, just like when the UK pension plans were trying to put up collateral, basically have enough cash to offset their derivative exposure. Raising that cash led to having to put up even more collateral because interest rates climbed even higher. It

It wasn't until the central bank stepped in to try to calm things that interest rates calmed. I saw some reports that

that 20-year UK bond yield could have been over 10%. It would have spun completely out of control as there was less and less liquidity and volatility spiked even more. Now, shorting volatility sounds incredibly risky, and there is definitely some risk there. Depends on how you structure it. And these are risks that I have been willing...

to take in my portfolio for less than 5% of my net worth. I own or used to own two ETFs. One is the Wisdom Tree CBOE S&P 500 Put Right Strategy ETF, PUTW. This strategy writes at the money put options, one month contracts, they collect the premium. And as long as that premium earned that month is greater than losses for the S&P 500 that month, then the

the strategy earns a positive return. This is sometimes known as a carry trade, this shorting volatility, because everything works great unless volatility spikes, or in this case, unless the stock market falls. And this has been a strategy that's returned on

on average about 6.5% to 7% per year. Again, small portion of my portfolio, but you can imagine in an environment today where VIX is close to 30, their portfolio is generating a lot of premium income, but it's also been a down market for stocks. And so the overall strategy is down 13% year to date.

Another strategy that more directly shorts volatility is the Simplify Volatility Premium ETF. SVOL is the ticker. It only started in May 2021, so it wasn't investing back in 2018 during Volmageddon when volatility spiked dramatically. But instead of providing 100% short exposure,

VIX, it has 25% exposure, so much less risk. And then it also buys out of the money VIX call options in case VIX spikes 100% in a day. And the idea is that will generate hopefully a 6% to 8% return. It's also down 13% year-to-date, similar to PUTW. And for comparison, the S&P 500 is down 23% year-to-date.

This particular strategy for S-fall, though, it works as long as VIX doesn't spike dramatically. But in a more stable environment, the idea is that because expected volatility is higher than actual volatility, typically there's an upward slope of the futures curves for VIX. So...

The ETF will enter in and short VIX out 30 to 60 days. And then if VIX doesn't spike because the spot VIX is lower than the future VIX, every time they roll over that futures contract, and granted, this gets a little complicated, but they earn a premium. They're earning money. And it can be a successful strategy unless VIX spikes. And 80% of the time, VIX has this upward sloping curve. It's known as contango.

I bought this ETF in June 2021, and I added exposure in March 2022 because VIX was high. So it was generating very high premiums and a dividend it paid each month. But then on September 23rd, around the time all this stuff was going on with UK government bond markets and the pension plans, the VIX curve went into what is known as backwardation. So the spot price is

is higher than the futures prices, and that curve is downward sloping, which means a strategy that shorts VIX could lose money every single month if VIX stays the same. If VIX goes up, they'll lose even more money. If VIX falls, they could actually gain money. But the underlying strategy of rolling over VIX futures contracts is a drag. It's losing money every month, as long as that VIX future curve is in backwardation with spot VIX higher than future VIX.

For that reason, I sold the ETF earlier this week because the underlying thesis wasn't there anymore. I'm patient. I can wait and see to where we get a positive VIX future curve.

My overall loss over my holding period was down, it was about 7% on a cumulative basis because, again, the yield, the premiums were so high. So there are ways that individual investors can participate and benefit from stability and volatility, but there's also many ways to get hurt. So what do we learn from this? Well, one, we can learn a great deal about financial markets when things do break. We can learn about liabilities.

liability-driven investments, these asset liability matching strategies. We can learn when something breaks how it works. How does the VIX and the volatility market work? We certainly know that even with something like long-term government bonds, that if doubt creeps in, they can move pretty dramatically. A 50% decline for UK, longer-term UK government bonds. For us, while volatility is a measure of risk, we care about losing money. That

That's why on Money for the Restless Plus, we don't focus on standard deviation or volatility. We focus on how much could you lose, the maximum drawdown. So know your risk. What is the potential loss for any particular strategy that you're invested in? The maximum drawdown. That's why we have a margin of safety. That's why when I'm shorting volatility, I only do it with a small percentage of my portfolio. I have many other different portfolio drivers, and that's what diversification is.

And then finally, we need to be careful with leverage. The UK pension plans got into trouble because they were over levered and then they had to put up collateral, more collateral, raise cash. And it was a function not of just trying to match their assets with their liabilities. If that had been the case, they wouldn't have had to sell anything. It was using derivatives, which have embedded leverage, embedded margin, embedded debt that require them to contribute

try to raise cash and be forced to sell in an illiquid market because everyone else is selling because of the herd behavior. And volatility spikes can lead to what's known as volatility spillover, where it spreads to all different markets around the world as investors act in tandem to reduce risk and to protect a portfolio because the volatility is to the downside, losing money.

So be very, very careful. But to study what will break next when volatility increases is both fascinating and it can really help us learn more about financial markets. That then is episode 405. Thanks for listening. I have enjoyed teaching you about investing on this podcast for over eight years now. But I also love to write. There's a benefit to writing over podcasting. And that's why I write a weekly email newsletter called The Insider's Guide.

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Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.