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The European Central Bank proved last week that the right promises, coupled with some effective marketing, can accomplish as much as deeds when it comes to managing market expectations.

When ECB chief Mario Draghi finally unveiled his save-the-euro plan after weeks of hints and a widely leaked report to the European parliament, markets reacted with near-euphoria. Stocks and commodities climbed, Spanish and Italian bond yields fell to their lowest levels in five months and already low market volatility declined to levels typically associated with healthier economies and stable market conditions.

The closely watched U.S. equity volatility gauge known as the VIX (the formal moniker is the Chicago Board Options Exchange volatility index) slid more than 8 per cent Friday to 14.33, capping a remarkable summer of declining worry and rising stock prices. Apart from similar readings late in December, the VIX hasn't stayed consistently low for this long since early 2007. (Just last October, the universally recognized fear gauge reached a high of 46.88.)

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In both cases of plunging volatility, market corrections soon followed. And there is no reason to believe we won't be seeing another one.

"I think it's going to be sooner, rather than later," says Ranjan Bhaduri, who has made a close study of the best strategies for institutions in difficult market climates. Hint: It's all about staying as liquid as possible. Which means being able to get one's money out of an investment instantaneously and without market impact.

"Volatility can't stay this low," insists Dr. Badhuri, a mathematician and chief research officer with Chicago-based AlphaMetrix, which connects hedge fund and institutional managers through an online marketplace, analyzes risk and monitors trades, among other technological services.

"I wish I could tell you it's going to have a spike in October or it's going to get resolved when the NHL Players' Association signs the CBA," he says, displaying his Canadian roots. "The problem is that nobody knows when the vol [VIX] is going to pick up. Warren Buffet doesn't know. Nobody knows."

The trigger could be just about anything – perhaps the realization that the vaunted ECB bond-buying scheme is just another ploy to gain more time; another political impasse after the U.S. election; or a more pronounced slowdown in China.

Dr. Badhuri points to the fact that trading volumes for equities and futures are considerably lower than typical levels during traditional rallies. This, he ventures, underscores the continuing apprehension of most investors.

The markets, he says, are lacking in positive sentiment. Which explains why so many hedge funds are parked in places like Apple. "People don't want to fight the trend, often. So if there's a winning trade, they'll stay in it. That's an easy stock to be in, and obviously a lot of hedge fund managers are there."

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Now that summer is effectively in the rear-view mirror, trading volumes are bound to pick up, as they do most Septembers. And with that, volatility is sure to climb.

Which brings us back to Dr. Badhuri's preferred line of defence: staying as liquid as possible. This does not mean loading up on more short-term government bonds or building cash piles higher. Instead, he argues, institutional fund managers should be looking at hedge funds that specialize in managed futures, including options and foreign exchange.

But surely short-term bonds and cash are a safer way to boost liquid assets, no? Not if you're a pension fund faced with a serious mismatch between assets and liabilities. "In the U.S., a lot of pension funds have too many liabilities. They have more pressure [to improve performance]. They don't necessarily have the luxury to just stay in cash or cash equivalents."

Yet some of these funds have a lot of capital tied up in relatively illiquid investments like real estate or private equity. He's not saying they should abandon such assets in dangerous markets. "But they should be paid properly for that. It's very easy to underestimate the value of liquidity. "

Indeed, he once co-authored a paper on an experiment to illustrate just that point. The idea was to address the "balls in the hat" probability problem and its relation to liquidity.

Put simply, six black balls and four white ones are placed in a hat. For every black ball removed, the player loses a dollar. Every white one brings a dollar gain. The balls aren't replaced and the person can stop playing at any time. Asked if they would play such a game, mathematicians and finance industry types instinctively said no, because the probabilities didn't seem to be in their favour.

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"It's a perfectly reasonable reflex answer," Dr. Badhuri says. But it's wrong. "The odds are actually in your favour to make money if you play this game correctly."

That's because the players control when to end the game. If they pull out a white ball on the first pick, for example, they should stop immediately and book their profit. "You get to decide when you want to stop. That is really perfect liquidity."

Many people rely on some sort of trading system to play the markets. All carry some risk. "But if you're dealing in the illiquid space, model risk gets magnified." The way to lessen that is through diversification into more liquid assets – "the only free lunch in finance."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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