VaR Shocks — Anatomy of a Forced Deleveraging

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A digital stock market chart displaying fluctuating graphs in red and green, with lightning bolts striking across the image, suggesting volatility.

Every now and then the market reminds you that the most dangerous risks aren’t the ones you can see coming. They’re the ones embedded in the risk management systems themselves. Value-at-Risk (VaR) shocks are one of those paradoxes in finance where the tools designed to keep portfolios safe can end up making everything worse. Understanding how they work, and why they matter, is essential for anyone managing leveraged portfolios or trying to make sense of the violent dislocations that periodically rip through markets.

The basic idea is straightforward enough. Many portfolios size their positions based on some measure of expected risk – typically volatility, asset correlation, and the resulting VaR. In calm markets, volatility is low, correlations are well-behaved, and risk models give you the green light to run bigger positions. Life is good, until something upsets the apple cart. Volatility spikes, correlations jump, everybody’s risk model says the same thing at the same time – cut risk.

Below is a deliberately simplified illustrative simulation to walk through the mechanics of a VaR shock. Think of it as a stylized version of what happens in the real world when a stress event hits a volatility-targeted portfolio, whether it’s a risk parity fund, a sector and factor neutral fund, a spread trader or a trend follower. Any leveraged strategy that dynamically adjusts exposure based on realized risk metrics.

We use two assets, each running around 15% annualized volatility in normal times, with correlations near zero. The portfolio targets a 15% volatility max and sizes positions accordingly. With two uncorrelated assets at 15% vol each, the math is generous as the diversification benefit from near-zero correlation means you can hold around 70-80% in each asset (roughly 1.5x total exposure) and still run portfolio-level volatility comfortably below the 15% limit, closer to 10%. That’s the beauty of diversification working as intended. Low correlations give you leverage capacity for free. The risk model sees calm vol, calm correlations, and allocates accordingly. Everything is in equilibrium. Now let’s break it.

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Are Your Alternatives Actually Just Equalatives?

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Let’s be honest about what’s sitting in most “Alternatives” buckets. Privates.

Private equity is a company raising capital from investors to build and grow their business. Public equity is a company raising capital from investors to build and grow their business. The only real difference? The platform they raise money on. Same story with private credit versus public credit, it’s lending to companies either way.

These aren’t alternatives. They’re “Equalatives”—a made-up word for investments that appear different but are exposed to the same economic drivers as what you already own.

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Macro Thoughts – January 2026

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Politics still loom large. The U.S. midterm elections likely act as a catalyst for further action by the current administration, particularly around affordability pressures. We expect that the President will campaign as if it were a Presidential race, with renewed efforts aimed at lower oil prices, lower mortgage rates and very visible support for consumers. Importantly, parts of the OBBBA were explicitly back-loaded: tax measures and refund dynamics designed to boost household cash flow this year, alongside corporate incentives intended to pull forward capex – and would anyone be surprised by a Trump signed tariff refund check? As those measures begin to hit, there is scope for a pickup in activity that could be powerful. The key economic question we’d love to grill the new Fed chair on: how sensitive is the economy to lower rates, should they come, and how does that interact with the AI-driven productivity gains we’re surely seeing? (The past couple of months look like yet another step change with agentic workflows) Technological change reshapes what work looks like, many jobs will surely transform and many new industries will get created. Same as it ever was.

The biggest question of the age remains unanswered. It seems clear enough to us from the US side; no longer willing to bear the large cost of absorbing the massive trade surpluses created in China and is reshoring and retooling to deal with it. Europe (via the Draghi report on competitiveness) seems to have woken up. At Christmas I broke the board games out at home. Couple of classics, Hungry Hippos and Risk. The combination of those strikes me as a rough model for the geopolitical environment. Take the marbles out of Hungry Hippos and replace them with the countries from the Risk board. The US and China are both hitting the hippo as hard and as fast as they can to get countries on their side and locked into their sphere of influence for trade, security, manufacturing and energy resources. Venezuela, broader Latin America, the Middle East, Asia, parts of Europe and Russia shifting (and being shifted) into trading and alliance blocs, all with the ability to move markets on short notice. The ball looks to be in China’s court. How this great confrontation plays out is the central theme of the next decade or so, making for an incredibly interesting set of macro opportunities.

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A Total Portfolio Approach for 2026: Understanding the Roles We Play

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A stylized symbol featuring a circular core with intersecting shapes creating a dynamic design, radiating light against a soft background.

As we close out 2025 and look toward 2026, it’s worth taking a step back to think about how we build portfolios.

The traditional 60/40 stock-bond allocation has been the go-to for decades. It’s been taught in business schools, recommended by advisors, and quietly implemented in retirement accounts everywhere. But some of the world’s largest institutional investors have been evolving their thinking. The Total Portfolio Approach, championed by pension giants like CalPERS and CalSTRS, offers a different way to think about risk and return, creating compelling opportunities for diversifying strategies like managed futures.

But here’s the thing: for this approach to actually work, each portfolio element needs to do its job. And we need to stop judging them all by the same yardstick.

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MLM Index: Why no equities? (Part 2)

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It’s late 1987. Institutional investors had just lived through the debacle of October 19, when the stock market collapsed, driven down by an idiotic idea … portfolio insurance. Shortly afterward, we had our first meeting with Rusty Olson, CIO of Eastman Kodak’s pension plan. Regardless of what you think of Kodak’s business acumen at the time, the pension plan was a star. Rusty was in the process of turning over every rock in the financial marketplace, looking for diversification for his very aggressive portfolio. He found us. We pitched him on the idea of managed futures as the ideal diversifier. Liquid, leverageable, and systematic. He loved it but with a caveat. We proposed a multi-manager managed account. But he, and his consultant, had no way of knowing how we were doing relative to some benchmark … there was no benchmark at the time. So we built one — the MLM Index. To my knowledge, it was the first rigorous, price based measurement of the risk premia available to futures traders.

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Macro Thoughts – Summer 2025

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2025 has been fascinating to watch through a macro lens. The Trump administration is seeking to reshape policy in ways that will reverberate for years to come. Trading relationships, defense priorities, tariffs, fiscal policy, monetary policy, immigration policy and the regulatory landscape are all on the table. Many of these directly impact the markets in which we operate. Last quarter started in the messiest of fashions, ‘Liberation Day’ setting tariffs based on trade deficits rocked the stock market and was swiftly paused in favor of ‘The Art of the Deal’ over the next few months. Stocks recovered, the contours of deals started to take shape and soon we had the One Big Beautiful Bill signed. Tax cuts were extended and investment tax credits were increased. Deficit arguments abound, most of which read like political talking points dressed up as economics. Are we talking about baselines vs current law or current year? Counting tariff revenue? Are we ascribing a growth multiplier? Our take on the macro aggregate is that deficits are not getting materially and hastily slashed so the accounting identity that public deficits become private profits still holds and growth is OK. Under the surface though there are some big changes in the composition of spending, especially when coupled with the new AI Action Plan. There is a broader discussion to be had on the role of the government in setting industrial policy and picking winners that is best saved for a glass of wine. However, they aren’t kidding calling it a ‘Big’ bill (‘Beautiful’ may be a stretch) but take the time to go through it, the answers to the test are in there. Money for defense and a desire to lead in AI.

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Managed Futures – Signal vs Noise

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Ask any self-respecting trend follower what kind of market environment favors their strategy, and you’ll get the usual suspects: volatility, uncertainty, macro and geopolitical stress, inflation, deflation, recession. But here’s the thing—those are just the conditions. The real driver? Signal versus noise. Trend needs signal.

In 2022, the signal was deafening: inflation fears, war in Ukraine, and ultimately, realized inflation. Since 2023? More like a symphony of noise. Just look at U.S. rates: 10-year yields dipped below 3.5% in April ’23 on recession fears… then hit 5% by October on “higher for longer.” They slid below 4% in Jan ’24 (soft landing), bounced to 4.5% by April (higher for longer again), dipped back under 4% in September (post-Yen carry unwind, recession vibes), then shot above 4.5% in Jan ’25 (pre-inauguration pro-growth Trump trade), and—you guessed it—dropped back under 4% in April (DOGE, tariffs, not pro-growth but outright recessionary).

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As We See It: Macro Thoughts

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At Mount Lucas we run both discretionary macro and systematic Managed Futures strategies.

  • While macro outlooks are useful for understanding Managed Futures returns, they aren’t very predictive (the “following” part of trend following). However, rule of thumb, they tend to do well when volatility increases in macro markets.
  • Managed Futures picks up a risk premium from hedgers on both sides of the markets, that risk premium shifts with uncertainty.
  • We have a new administration coming in shortly that sees volatility as a feature for negotiating leverage and has big macro policy goals.
  • These policy goals run directly through the macro instruments we trade – bond yields, currencies and commodity markets.
  • Investors need exposure to these macro markets to help diversify traditional investments.

Where do we see sources of volatility relative to the markets we trade?

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Managed Futures – Overcoming Human Bias

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2022 was a fantastic year for showcasing the benefits of adding Managed Futures to the portfolio. Inflation rears its ugly head after 40 years and commodities rip higher during the Ukraine War. Managed Futures, offering exposure to both the long and short sides of return distributions, got you long commodities and short bonds. No other asset class brought you that kind of protection in 2022. Not Gold, not TIPS, not Bitcoin. However, after down single digits in 2023, and another flat to down year in 2024 amid strong stock market results, the naysayers return.

Managed Futures – computers love us! Humans…not so much. Why is that? Take pretty much any sufficiently long Managed Futures track record, or index, run it through asset allocation models and efficient frontiers, the answer is pretty much always the same. Uncorrelated returns, with strong negative correlations in periods of market stress, lowers overall portfolio volatility and drawdowns. The efficient frontier goes up and to the left, improved returns, lower volatility, better portfolio Sharpe. The quants, and CFAs, and nerds all agree…on paper it works. For the seasoned veteran, the RIA, the institutional consultant, holding Managed Futures in a portfolio through time, not so easy with the clients.

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The FLATION Complication

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We speak with a diverse range of investors—domestic and international, institutional and retail, alternatives-focused and equity-centric. Typically, they have a variety of questions and concerns driving their current thinking. However, in recent weeks, there’s been a singular focus: the return of President Trump. It’s remarkable how much of a Rorschach test he has become.

For macro topics like inflation or growth, we usually see a fairly narrow range of opinions—around 10-15% of people expecting slightly lower inflation, 10-15% anticipating it to be a bit higher, with most clustered near the target, expecting the status quo. Currently, not a single person thinks we are in a state of equilibrium. On one side, 50% believe we’re headed for runaway inflation fueled by exploding deficits, Fed pressure, eroding confidence in the USD, and soaring commodity prices due to global turmoil. The other 50% foresee a deflationary crisis spurred by the deportation of 10 million immigrants, a $2 trillion reduction in the federal budget, and a rampant USD disrupting emerging markets and driving commodity prices down. Adding to this uncertainty, President Trump, the world’s largest one-man volatility machine, has teamed up with perhaps the only person who could rival him, Elon Musk. Volatility squared.

These factors, among others, have realigned market assumptions, significantly increasing the likelihood of problematic inflation or deflation over the next twelve months. Investors face a FLATION complication.

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