Why the Brexit is Binary Bollocks for Investors

We can’t help but notice that everyone’s all in a tizzy about this Brexit vote. We’ve got the Dax down about -7%, the VIX up some 40% in the last week and a half, and a whole range of other markets (see Gold, the British Pound, US 30yr Bonds) reacting to what could be a shock to the system. We’re also seeing some non direct reactions, such as clearing firms raise margins on Eurex products ahead of the vote.  What’s all the Brexit fuss about… here’s the Economist with a Background guide to ‘Brexit’.

Now, you would think global macro and managed futures based investments would welcome such a “shock”, and they have been excited to see the uptick in volatility the past few weeks, which has brought them from the lowest point of the year back into positive territory after a run of about +2.72% from its lows it hit on May 19th via the SocGen CTA Index.

But while the run up to the Brexit vote has caused some directional volatility, the vote itself is likely to be problematic for most systematic investment programs. You see, what’s happening now is the lead up… it’s people positioning their portfolios for what may come. It’s people lightening up on exposure, adding safety, and so forth. When enough people do that sort of thing at the same time – you get three day down moves in the Dax like we’ve seen. You get a mini rush for the exits that can push prices in a certain direction for a certain amount of time. What we in the business call a trend, or momentum. We love these – they’re measurable, cyclical, capturable.

Binary Events

But what happens on the day the vote is tallied is something different altogether. The vote itself is a binary event. It either passes or it doesn’t. If it passes, x, y and z happen in markets. If it doesn’t, a, b, and c happen in markets. You may be familiar with another popular binary event, the coin flip. Heads – you win, Tails – you lose.  Suffice to say that the guys and girls with PhDs and sophisticated algorithms for tracking market prices and identifying patterns don’t quite like their life’s work boiling down to a coin flip. They despise these binary events, as they temporarily invalidate all of the math and research which go into the modern day systematic global macro or managed futures program.

PS – We can’t help but think of this when hearing Binary

Now, of course – most programs are diversified across markets and market sectors, designing their risk budgets to not lose too much (or gain too much) on any one day’s move in a single market. But there’s still outsized risk (and possible reward) from markets quickly reacting to the binary outcome one way or another. What might this outsized risk look like?  Well, you might see a trade’s risk eclipsed by three to five times. For a program that risks less than 1% of their total portfolio, that’s not such a big deal. For a program that risks 10% to 30% of the capital on each trade – that could be a very big deal.  You can think of a binary event as concentrating weeks to months’ worth of market movement into a single day’s trading session, meaning you could see weeks to months of gains/losses in that day.

Here’s what that looks like in real life. Remember this binary event (which was actually a surprise attack) – the Swiss depegging their currency. Here was our nifty graphic of that tremendous one day move (the currency moved the equivalent of 4,300 Dow points in an hour), which packed over 1,000 days of movement into a single day.

(Disclaimer: Past performance is not necessarily indicative of future results)

Of course, diversified programs on the wrong side of this binary event only dropped -1% to -5% on this trade, from what we can remember; and the asset class as a whole was up that month, showing the value of a diversified portfolio. But there does seem to be more and more of these binary events recently, with the world anxiously awaiting the result of a US Govt. shutdown vote, TARP vote, Greek referendums, German bailout votes, Spanish austerity, and so forth. At the same time, markets like Oil have become less reliant on binary events like OPEC meetings thanks to OPEC’s waning power.

In the end, these binary events are part of the investment landscape. There will surely be more than a few managers and investors yelling bollocks as they watch a market they have exposure to move wildly in reaction to the vote. But they’ll be quick to remember that these events add volatility before and after, which is a good thing; even if the performance on the day of the event is no better than a coin flip. They’re part of the equation, even if they don’t fit in the equation.

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