Quants Corner - Knowing when to jump: risk management in extraordinary times - Crossing to safety in extraordinary market conditions

Knowing when to jump: risk management in extraordinary times - Crossing to safety in extraordinary market conditions

What had been a relatively measured response to the coronavirus outbreak that started in China around the New Year became an increasingly disorderly stampede for the exits in late February. As COVID-19 spread across the globe, US stock market took a series of hits culminating in a 7% drop on March 6 that triggered the so-called “circuit breaker” – suspension of trading – for only the third time since its adoption.

In the current climate, with new restrictions being introduced by countries around the world, safety is uppermost in the minds of many investors. But what is safe, and when should investors make the switch to, or between, less risky asset classes?

The usual suspects?

Eager to find safe havens, investors poured money into US bond funds – especially those dedicated to investment grade debt – during the first eight weeks of this year (see Chart 1).

Chart 1 – Daily Fund Flows to US Bond, Equity & Money Market

On March 3, however, the US Federal Reserve -- an effort to contain the coronavirus’s economic fallout -- unanimously voted for an emergency rate cut. That move helped drive the yield on 10-year US Treasuries below 1%. It also prompted shocked investors to move into cash: $107.9 billion flowed into US money market funds during the five days that followed the Fed’s rate cut.

As the scramble for ‘safe heaven’ assets gathers pace, investors are searching for those that produce the best yield with the least risk under the current stressful environment. Junk bonds, which have proved resilient during previous bouts of risk aversion, are not making the cut during the current crisis (see Chart 2 below).

Chart 2 – Daily Fund Flows to US Bond, High Yield vs Investment Grade

Flagged by flows

From a risk management perspective, one approach to identifying ‘safe haven’ assets classes, and timing rotations into or out of those asset classes, involves a straightforward modelling of flows against the performance of a key benchmark.

To build this model, we simply look on a daily basis at the five-day moving average (MAVG) of the flows for US High Yield, US Investment Grade, US Money Market and US Equity Funds. Flows, for the purposes of this model, are measured as a percentage of collective fund group assets under management (AuM) rather than in cash terms.

Once the MAVG is calculated and then ranked, the model calls for investors to rotate their exposure from the lowest ranked group to the highest ranked group.

If we run the model with an equity focus, the benchmark we use is the S&P 500 index. Chart 3 shows the total number of days for each calendar month since 1Q16 that S&P 500 had a loss while Chart 4 counts the number of times (a) the model signaled investors should rotate to a fund group other than US Equity Funds on T-1 and (b) the S&P suffered a loss the following day (T).

Chart 3 – No. of Days that S&P 500 Loss

Chart 4 – No. of Signals (Signal not in Equity at T-1, and S&P has a loss at T)

Chart 5 below shows, in percentage terms, the number of times each month the model’s signal to be in an asset class other than US equities was followed the next day by a drop in the S&P 500.

Chart 5 –Good Calls %

What’s ahead?

Although US Equity Funds enjoyed moderate inflows seven of the eight trading days between March 3 and March 12 (Chart 6), the model consistently ranking other asset classes higher. That the model was right to do so was born out by the S&P’s continuing falls.

Chart 6 – Daily Fund Flows to US Equity

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