Seth Klarman, Baupost's founder.
Baupost Group, a $30 billion hedge fund, has laid out a road map for market chaos.In a second quarterly private letter that was reviewed by Business Insider, Baupost said that the problem lies with a signature feature of current markets: low volatility.
That low volatility could be the harbinger of a crisis to come.
That's because when there is low volatility, investors tend to take on more leverage - borrowing money to juice bets - which could trigger problems later on.
"While leverage is not directly responsible for every financial disaster, it usually can be found near the scene of the crime," Jim Mooney, Baupost's president and head of public investments, wrote in the letter. "The lower the volatility, the more risk investors are willing to or, in some cases, required to incur."
He added: "Structural leverage linked to low realized volatility may well prove destabilizing and the precipitant, or at least an accelerant for the next financial crisis."
Assets whose performance is linked to volatility include a huge amount of money - probably in the hundreds of billions of dollars, he estimated. These funds, including quant funds and so-called risk parity funds, target a specific level of risk, and when volatility spikes, sending risk upwards, it can trigger selling. That can then set off a cycle: volatility leads to selling, which leads to volatility, which leads to selling.
"As such, any spike in equity market realized volatility, even to historical average levels, has the potential to drive a significant amount of equity selling (much of it automated). Such selling would, in turn, further increase volatility which would call for more de-leveraging and yet more selling."
To be sure, Mooney cautions that investors can't know whether an uptick in volatility is "imminent or even inevitable," nor that it would necessarily have cataclysmic effects, "although it certainly could."
"We remain in a market that is broadly expensive and largely indifferent to risk," Mooney wrote in closing the letter. "No one should be lulled into a false sense of comfort by the illusion of stability which surrounds us."
Mooney's warning contrasts with the VIX, an index measuring investors' fear. Last week, the index hit its lowest level in 24 years, a sign of investors' confidence in the bull market.
Earlier this year, Baupost's founder, Seth Klarman told clients that investors were missing huge risks and raised red flags about the then-new Trump Administration's effects on markets. For instance, Klarman cited Trump's proposed tax cuts, which could considerably raise the government's deficit.
Baupost managed about $30.3 billion as of the start of this year, according to the Hedge Fund Intelligence Billion Dollar club ranking. Current performance was not available, though Baupost said in its letter that it has had positive performance this year.