By Edward Chancellor
LONDON (Reuters Breakingviews) - Investors who have earned big bucks by betting against VIX futures were hammered when volatility spiked on Monday. The global stock markets also dipped sharply. Conventional wisdom suggests it’s a good thing to take a little froth out of the market. Besides, the economy’s fundamentals remain robust, adds U.S. Treasury Secretary Steven Mnuchin. And it’s true that investors quickly recovered their nerves in the following days.
Most investors, no doubt, would prefer to forget this troubling start to the week. But that would be a mistake. Shorting volatility has been one of the most prevalent and conspicuous features of the markets since the financial crisis of 2008. A crack has now appeared in the great volatility bubble. Investors should take note.
The Cboe Volatility Index, known as VIX, which measures expectations of volatility implied by S&P 500 Index stock options, reached all-time lows in recent months. Yet on Monday, the so-called “fear index” more than doubled. Traders who were selling so-called “vol” got creamed. An exchange-traded note, the VelocityShares Daily Inverse VIX Short-Term ETN (or XIV), which sold VIX futures, lost 84 percent of its value in after-hours trading. This triggered what’s called an “acceleration event,” which led to the fund’s closure by Credit Suisse. Its investors face a near-total wipeout.
Short volatility products, such as XIV, have been particularly popular with retail punters in recent years. It’s easy to see why. One dollar invested in XIV at its launch in late 2010 had turned into $15 by the start of this year. Gains in the 12 months to mid-January exceeded 150 percent. Selling volatility was so profitable because the futures have long traded at a substantial premium to the VIX index. This fat premium existed because, in the aftermath of the crisis, the market has been willing to pay more for protection against another bout of turmoil.
Christopher Cole of Artemis Capital calls this the “bull market in fear.” And a raging one it has been. A virtuous cycle developed, since selling VIX futures served to dampen volatility. Or as Cole puts it: “low volatility begets low volatility.” Trouble was brewing, however. When market volatility declined last year, XIV had to sell more and more futures at lower and lower prices. Then, all of a sudden, the virtuous cycle turned vicious: as the VIX index soared upwards and XIV, its inverse, blew up.
At first sight, this looks like a familiar story of greedy but naïve retail investors lured by predatory Wall Street into a complex financial product with the promise of too-good-to-be-true returns. That’s not an unfair description of events, but risks ignoring the all-important context.
There’s a reason volatility has, until recently, been dead. Ultra-low interest rates and the massive expansion of central bank balance sheets in the United States and abroad are the prime culprits. Former Federal Reserve Governor Kevin Warsh has been forthright on the matter, stating that quantitative easing “works because we take volatility out of the market.” In an interview last year, the VIX’s inventor Dan Galai said much the same thing.
Faced with a loss of income, people have reached for yield. Some investors turned to selling volatility, similar to the way, in the previous cycle of easy money, they snapped up high-yielding subprime securities. Shorting VIX futures has not been the only “short vol” trade out there. Selling put options on the S&P has also become popular for pension funds – a strategy known as “overwriting” – and even retail investors. Margin loans, which are implicitly short volatility, climbed to a record high at the end of 2017, according to FINRA data. The returns of many so-called “yield-enhanced” products are likewise inversely related to market volatility.
That’s not all. Many fund managers have been selling volatility, whether they realise it or not. The historic performance of hedge funds closely tracks the returns from selling put options, Massachusetts Institute of Technology Professor Andrew Lo has observed. In recent decades, one of the most profitable and reliable investment strategies has involved piling into equities after the stock market has fallen. But “buying the dip” is just another version of the trade. Modern finance teaches investors to equate recent market volatility with risk, and scale their positions accordingly. For instance, many implementations of the risk parity strategy, popularized by Ray Dalio of Bridgewater Associates, use “volatility targeting” to determine asset allocation.
Credit is yet another short volatility position. Easy money has suppressed defaults and yields on high-yield bonds. That hasn’t put off investors, however. Market liquidity and volatility are more or less synonymous. Investors who purchase exchange traded funds, which hold illiquid leveraged loans or corporate bonds, are effectively shorting volatility. There’s an international dimension to all this. Hélène Rey of the London Business School found that global capital flows since the turn of the century have been closely correlated with movements in the VIX index. Investors who search for higher yields in emerging market debt are like just about everyone else, short volatility.
The greatest of all carry trades in recent years has been the corporate buyback boom. Companies have taken on trillions of dollars of debt to repurchase their stock. It’s often noticed that share buybacks proliferate when the market is rising but evaporate when the market collapses. That’s because leveraged buybacks, like margin loans, are a “short vol” trade, says Cole. Sovereign debt markets, where yields and volatility have been explicitly suppressed by monetary policymakers, shouldn’t be overlooked either.
In short, the low volatility environment infects the entire investment world. There has been no place to hide, with the exception of cash which for nearly a decade has delivered negative real returns. There’s another aspect to consider. The U.S. economy in recent years has become increasingly financialized. The banking, insurance and real estate sectors are responsible for a fifth of U.S. GDP growth. Corporate profits are at near-record highs. It’s almost certain a good chunk of those profits are directly or indirectly related to the low volatility environment.
This all may be about to change. The great volatility suppressant is stepping back. The Fed continues to hike rates, albeit slowly. Quantitative tightening is slowly shrinking the Fed’s balance sheet. Furthermore, the central bank’s freedom to respond to market turbulence is compromised by concerns about rising inflation. If those concerns persist, further bouts of financial turbulence are likely. Volatility sellers beware.
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