Skew, Convexity, and the Hidden Risks in Systematic Investing | Systematic Investor | Ep.370

Episode Overview

• Global financial markets have seen escalating political intervention and central bank influence since the late 1980s, transforming market dynamics and risk perception.
• The economy has become highly financialized, with the stock market now acting as a primary driver rather than a reflection of GDP, fostering a belief in "risk-free" markets.
• Traditional volatility metrics are increasingly insufficient for measuring true market risk, which is better captured by factors like skew and convexity, particularly evident in the options market.
• The current era of massive debt and money printing is setting the stage for an inevitable inflationary cycle, acting as a historical stabilizer that imposes a wealth tax.
• These market distortions create significant opportunities for investors who understand and exploit the mispricing of risk, moving beyond short-term optimization to long-term market cycles.

Key Concepts

• Escalating Political and Central Bank Intervention: Governments and central banks have progressively increased their support and guidelines for markets since the late 1980s (e.g., 1987 crash, dot-com bubble, GFC), leading to a perception of continuous intervention and a "Fed put."
• Financialization of the Economy: The stock market's size relative to GDP (Buffett ratio) has grown dramatically, indicating it now drives the economy rather than merely reflecting it, creating a self-reinforcing cycle.
• Misperception of Risk-Free Markets: A prevailing mindset suggests markets are effectively "risk-free" due to constant intervention, leading investors to disregard daily fluctuations and implicitly underwrite tail risk.
• Inevitable Inflationary Cycle: The current high levels of debt and continuous money printing are unsustainable and will inevitably lead to an inflationary cycle, historically acting as a stabilizer and a "massive tax on wealth."
• Critique of Traditional Risk Metrics: Standard deviation of returns (volatility) and Sharpe ratio are inadequate for measuring true risk in today's markets, as they fail to account for "skew" (asymmetry of returns) and "convexity" (non-linear risk). Many hedge fund "alpha" is attributed to implicit "tail risk exposure" rather than skill.
• Options Market as a True Risk Indicator: The options market's highly negative skew indicates an underlying awareness that liquidity can dry up and volatility can spike rapidly during downturns, a critical insight often overlooked by many risk managers.
• Market Opportunities from Mispriced Risk: The current environment presents "incredible opportunities," likened to being larger than the mortgage crisis, due to the widespread misunderstanding and non-integration of skew and convexity into investment models.
• The "Real Arbitrage" Opportunity: Exploiting the misalignment of different risk measures by buying insurance in Delta 1 markets, trading short-term breakouts when volatility is low relative to other risk indicators.
• CTA Style Drift and Adaptation: The CTA industry has seen a shift towards longer-term and diversified strategies, incorporating elements like long equity/fixed income biases, carry trades, volatility selling, mean-reversion spreads, and "risk parity-like" approaches, moving away from underperforming short-term trend following.
• Optimization Dilemma and Human Bias: Investors face a philosophical choice: optimize for recent market cycles and factors that have performed well recently, or for much longer (50-100 year) historical cycles, recognizing that human cognitive biases often lead to suboptimal short-term decisions.

Quotes

Top 5 notable quotes with ABSOLUTE TIMESTAMPS and context from across the podcast. Each quote MUST be its own bullet point.

• At 3:30 - "So starting from the late 80s and 1987, it became clear for the political system, the governors in America, that markets needed more support and more guidelines in order to avoid 1987 type of situations to happen. Then you had the internet bubble 01 to 03, which was a difficult period for the markets, and there was another layer of, you can call it political interventionism in the markets. And then finally you had the GFC, which was quite an intense event where the Fed and the Treasury had to intervene even more in the markets. And what you see since then is that the political influence on the markets are becoming stronger and stronger." - Nigol provides historical context on the escalating role of political intervention in market stability.
• At 4:26 - "Now to give that context where the Buffett ratio, so if you see the importance of the stock market in the US economy is becoming bigger and bigger. So if you think of the Buffett ratio, which is the size of the stock market relative to GDP, long-term average for that ratio is that the stock market is about 70% of the size of GDP. Today we're over 200%. So effectively the stock market has gone from becoming the tail of the dog to becoming the head of the dog. So the US economy is actually driven by the stock market. So 1% return in the stock market is giving you 2% of GDP in new liquidity and that's very, very, very influential." - Nigol illustrates the dramatic increase in the stock market's influence on the US economy.
• At 12:35 - "Niels, 100% that this is not like an end of the world scenario. It's just a cycle and the current investor mindset is that this is the full market cycle that we're seeing. In reality, we're not. That's the only question, which means the tilt of risk and exposure and leverage that they're allowing themselves to have is just different than if you took the whole market cycle into account. So typically, out of this situation, it's not the end of the world. It's just an inflationary cycle that comes and it comes 100% of the time. There's no way you can have this amount of debt and not end up and continuing to print money without without inflation as the stabilizer." - Nigol connects current market behavior to an inevitable inflationary cycle.
• At 24:57 - "There's an incredible opportunity in the market today, bigger than the market and mortgage crisis of a GFC." - Migol highlights a major market opportunity.
• At 25:05 - "The fact that convexity and skew are not in everyday language, and volatility is, effectively people are measuring risk in one specific way, really the risk is not there. Volatility today does not measure risk." - Migol explains that standard deviation of returns (volatility) doesn't capture the true risk when skew and convexity are not considered.

Takeaways

• Re-evaluate Risk Metrics: Investors must move beyond traditional volatility measures and incorporate skew and convexity to truly understand market risk, as standard deviation no longer adequately captures potential tail events.
• Acknowledge Political Influence: Recognize the profound and growing impact of political and central bank intervention on market dynamics, which has created a perception of "risk-free" markets that encourages greater risk-taking.
• Prepare for Inflation: Understand that the current environment of massive debt and money printing points to an inevitable inflationary cycle, which will act as a significant "tax on wealth" and necessitate adaptive investment strategies.
• Seek Mispriced Opportunities: Significant market inefficiencies exist due to the widespread misunderstanding of true risk factors, offering "incredible opportunities" for sophisticated investors to exploit these mispricings.
• Adopt Long-Term Perspective: To counteract human cognitive biases, investors should optimize strategies for longer historical market cycles (50-100 years) rather than chasing factors that have performed well in the most recent short-term cycle.