Is the ‘risk on, risk off’ investment style on or off?

12th January 2012

The "risk on, risk off" concept has been around for a year or so.  But until now, it has been largely confined to hedge fund managers, derivatives dealers and day traders. But it is gaining greater traction so while most investors will not use it, they do need to know what it's all about simply because others could go "risk on, risk off" and move markets.

What exactly is it?

Risk on, risk off is effectively trading on trouble. Probably the past twelve months have seen more high profile turmoil than in any other year over the past two decades – from natural disasters such as the Japanese earthquake and tsunami to man-made crises including eurozone debt difficulties.

When economic tensions are low, investors take more interest in aggressive assets such as emerging market equities. When the fear headlines increase, it's "risk-off" so money retreats into safer havens such as gold or US Treasuries.

Thus far, most investors are agreed – unless you are prepared to take a long view and buy into weakness, you reduce risk when global tensions are high and increase exposure to aggressive assets when turmoil turns down.

Moving on to the advanced level

Markets tend not to stick with basic concepts if they can find something more complex so players can gain – even for a few minutes – the advantage over slower participants.

So risk on, risk off plays rarely involve plain vanilla long term holdings of riskier or less risky assets. Besides having no appeal to traders or hedge funds, the ups and mostly downs of the past year have come speedily one upon the other. The market's volatility spooks the market into more volatility.

The first stage, according to US futures broker CME Group, is to take outright positions in markets using derivatives to create long positions on the S&P 500 or the Australian dollar (when risk is low) while higher risk pushes investors to gold and US government bonds.  During periods of visible economic distress, these markets often become very responsive to the same concerns and exhibit high correlation.

Market participants rarely like to leave matters as simply as that.

The next stage is the cross-asset transaction. Take a pair of currencies – one riskier than the other – such as the Australian dollar (AUD) and the Yen (JPY). The spread between these two is now seen as a leading measure of macro fear. When it's risk-off, the commodity heavy AUD is ascendant – higher factor risks lead to the conservative Yen (it's gained substantially since the 2008 crisis).

So risk off players buy AUD/JPY – going long on the Australian currency and short-selling the Yen. When it's risk on, you sell this same combination. Now you are shorting the Aussie dollar and going long on the Yen.

Other similar pairs -and there are lots – could be the euro/US dollar, eurozone bonds/US Treasuries, and S&P500/gold.  In each case the first named is the higher risk asset.  Or if you really want to be complicated, try the S&P500/Vix (the Volatility index). When stocks rise, volatility falls and vice versa.

That's because stocks tend to rise in small calm amounts but fall suddenly in larger lumps. The S&P 500 and the Vix are inversely correlated – if you turn the S&P on its head, it moves very much like the Vix.

But none of this pleases those running company investor relations departments who have to explain to stockholders why their bonds or shares are falling when the firm is doing well. For looking for macro events, the market moves the focus away from fundamentals such as individual company analysis. Everything tends to correlate away from the stock picker. So they tend to talk down "risk off", even more talk down the whole concept.

Stockbrokers, who expect individual stock purchases and make their money in a different way to futures brokers, also tend to be dismissive.

"Correlations are starting to come down. It's a function of where we are in the economic cycle and the market cycle," one said. "That will serve investors well in terms of fundamentals becoming more important. Diversification starts to work a little bit more effectively as you bring more individual investors back into the market and also has the effect of bringing correlations down.  Diversification of risk is a big one for most investors, and it becomes almost impossible if everything is moving in the same direction."

If risk on, risk off fades, then expect stock pickers to come to the fore. But it all depends on how long volatility and the sense of crisis remains before the eventual return to the longer term equilibrium.


More from Mindful Money:

Investment Tools: Systems to steer through crisis

Volitility ETFs – Profiting from a crisis

UK investors pull out of equities – but should they be fearful?

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