Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

Foreword

In today’s tightly coupled financial system asset class returns are so highly correlated, that investors and asset managers are, to a much larger degree than previously, and very often much more than they realize, essentially undiversified and subject to the risk of abrupt and severe wealth destruction. The ultimate risk, which far exceeds the widely touted notion of tail risk, is the systemic risk which arises when liquidity in capital markets evaporates as it did in 2008 and episodically has done since – most notably in May 2010, in an incident known as the Flash Crash, and in the fall of 2011 when correlations were at historically elevated levels.

Conventional asset allocation tools and techniques have failed to keep apace with the changing financial landscape which has emerged since the 2008 global financial crisis. In addition to a decline in the quality of market liquidity, in part epitomized by the prevalence of algorithmic churn, a new paradigm of risk on/risk off asset allocation has emerged. Risk on/Risk off, sometimes abbreviated to RoRo, is a style of trading and macro allocation strategy, adopted by a broad cross section of participants in the financial markets, where positions are taken in several closely aligned asset classes depending on the prevailing sentiment or appetite for risk.

The following table shows, in summary form, a delineation between a set of asset classes which can be categorized as risk on and those which may be designated as risk off. ...