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Fill In The Blank: VaR Is To Illiquidity As Gasoline Is To _____

Fill In The Blank: VaR Is To Illiquidity As Gasoline Is To _____ by Douglas J. Peebles and Ashish Shah, AllianceBernstein

Few things make investors queasier than volatility. But usually, the best way to settle the stomach is to breathe deeply and ride out the storm. Regrettably, fewer big investors are doing so nowadays—and that worries us.

Here’s why: bond market liquidity has been drying up, and a growing tendency among large investors to shorten their investment horizons and react to short-term volatility spikes could make the situation worse.

This is because many large investors—pension funds, insurance companies and even high-net-worth individuals—have embraced “risk-aware” strategies. These use volatility-managed or value-at-risk (VaR) techniques to measure their level of portfolio risk. If the risk level falls, managers generally buy more assets. If it rises above a certain level, they generally sell assets to bring it back into line. This behavior can be dangerous, especially when it is driven by a static rules-based investment process.

Focusing on Risk Management

These strategies became popular after the global financial crisis—and it’s easy to see why. Investors who had suffered catastrophic losses in 2008 were determined to avoid a repeat performance.

But here’s the thing about VaR strategies: they work best when the supply and demand of liquidity within the marketplace are matched. This is because managers must be able to rebalance their portfolios when risk measures change. When the demand for liquidity overwhelms the supply of it, the execution price suffers.

A Crowded Trade

With so many investors using these...


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