Dr. Michael Hunstad, Chief Investment Officer for Global Equities at Northern Trust Asset Management, joined Keith Black, Managing Director of RIA Channel, to discuss how changing investor habits are increasing market risks.
Since the global financial crisis, the frequency and severity of volatility shocks hitting both the stock and bond markets have been increasing. While the volatility of both stocks and bonds is increasing, recent years have seen an increase in the correlation between stock and bond returns. The increased correlation makes it more difficult to reduce risk simply by portfolio diversification.
Dr. Hunstad attributes changes in market microstructure as contributing to the increasing tail risks. Over twenty years, the portion of institutional assets invested in passive index funds has increased from 5% to 50%. As less institutional capital is participating in the price discovery process, retail investors are becoming more influential.
When markets decline, they go down more than they used to, increasing tail risk. High-frequency trading may withdraw liquidity when it is most needed, and zero-day options are adding volatility to the market. The markets are becoming more inelastic, with smaller dollar volume leading to a larger percentage change in market returns.
Due to increased volatility of individual assets and rising correlation between asset returns, asset allocation and diversification may not be sufficient to reduce volatility risk. Investors now have to be cognizant of how the construction of equity and fixed-income portfolios contributes to risk. Investors now need to consider how to reduce the volatility of returns within their equity portfolio and within their fixed-income portfolio.
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