In early 2020, SPY (SPDR S&P500 ETF Trust), GLD (SPDR Gold Trust), and IEF (iShares 7-10 Year Treasury Bond ETF) fell simultaneously. Most people think that Gold and US treasury bond should rise while the stock market falls as they are the safe assets. Here are some reasons to explain why they cannot hedge market risk.
Most hedge funds have a hedged portfolio. Their portfolios appear to have gone through a significant amount of deleveraging in March of 2020. Multi-strategy funds suffered losses so that they needed to rebalance the portfolio by unwinding their equity market neutral books.
Most hedge funds use leverage to increase profit. In normal conditions, leverage allows portfolios to be more flexible and less constrained. Leverage gives long/short equity managers the flexibility to tune their books to the desired size, and add securities without resorting to exiting positions in other parts of the book to fund those purchases. The entire concept of risk parity relies on using leverage to scale up exposure to lower volatility asset classes (in most cases fixed income) to match the volatility of higher volatility asset classes (in most cases commodities and/or equities). Managers also use leverage in basis trades, convertible arbitrage, and the list goes on.
Start with an external shock to markets: Coronavirus fears send stock markets downwards and demand for safe havens like Treasurys upwards. That’s not a panic, even if the size of those moves is substantial. It’s just a rational move driven by the anticipation of economic damage from a global pandemic. However, it doesn't mean the bond price will rise if stock markets downwards. Most of the time, those hedge funds also close bond positions because they need to rebalance the portfolio.
Here is the example, 55% of hedge fund A's portfolio is bond and another 35% is risker equity portfolio. If hedge fund A suffers a huge loss in the equity market, they need to close some equity positions and some bond positions in order to obtain the best risk-parity ratio.
Therefore, the reason why safe assets cannot hedge the stock market is constraints. Constraints may cause a market participant to feel forced, or actually be forced, to unwind their portfolio, even if they don’t believe it’s the best move from an “optimal” long-term perspective.
Let’s use the above example of leverage. If you are levered and your portfolio takes a large mark-to-market loss, you might receive a margin call. If your losses continue, you get additional margin calls and, eventually, one you can’t meet. You have to sell your position (or your broker does it for you), even if you think it’s going to rebound.
Even in the case where your losses are modest, you fear additional losses in the future and look to reduce your positions and leverage to avoid future margin calls.2 If you were not levered, you would not be as constrained in your decisions; you might choose to hold onto your investments from a more stable footing. Where leverage once enabled flexibility, it now has the opposite effect of a pernicious constraint.
Usually, those safe assets tend to rise after portfolio deleveraging. We think it is a good reason to explain why the correlation between safe assets and the equity market goes positive during March 2020.
Markets can never really be unrelated as long as there are globalization and players that hold exposure in both markets. Losses in one market generate mechanical rebalancing, grabs for cash, and overall weakness, which causes pressure to unwind in other markets, which causes losses there as well. Notably, similar to a bank run, none of this needs to actually be true, the run will happen so long as others fear it might be.
Nevertheless, this hypothesis has its own weakness. For example, the correlations between the bond and other foreign market crises (ie. Chinese market crisis, Japanese market crisis, European market crisis) don't go to a significant value. That means: US treasury bonds can hedge non-US market downward risk.
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