When bets that stock-market volatility would remain subdued—previously described as perhaps the world’s most crowded trade—turned sour Monday, the shakeout was swift and brutal. The question for investors is whether there are any aftershocks to come.
A record-breaking spike in volatility as measured by the Cboe Volatility Index, or VIX
on Monday appeared to amplify, if not drive, that day’s stock-market carnage. The S&P 500 index
and Dow Jones Industrial Average
were under renewed pressure Thursday amid lingering jitters over the potential for a rise in volatility to further roil financial markets.
Further shocks, however, weren’t expected to come from the same products that were the culprits in Monday’s turmoil. That is because volatility spike slammed two of the most popular inverse volatility products amid a flushing out of leveraged bets on falling volatility.
“In terms of further market risk, at least stemming from the VIX complex, I think that’s over,” said Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, in a phone interview Wednesday.
Cleared out ‘almost overnight’
Analysts Jitesh Kumar and Vincent Cassot at Société Générale offered the chart below in a Wednesday note, observing that the bulk of leveraged positions in VIX exchange-traded products was “cleared out almost overnight,” leaving assets under management at levels seen in 2012-2013.
Still, it appeared some retail investors were eager to jump back into the short volatility trade, with assets in the ProShares Short VIX Short-Term Futures
exchange-traded note rebounding to more than $427 million from a low of $72 million on Monday, Bloomberg reported, though well off its peak of $1.7 billion at the beginning of the month.
Meanwhile, are there other volatility-oriented strategies—such as volatility targeting or risk parity—that could cause trouble down the road? Marko Kolanovic, J.P. Morgan’s head of derivatives strategy, warned in a Monday note that the rise in volatility would clearly contribute to further outflows on the order of around $100 billion from those and other systematic strategies in subsequent days.
But Chintawongvanich argued that the impact would be minor compared with the fallout from the implosion of the short VIX funds.
Shorting volatility via futures and related products “is a completely different strategy from volatility targeting or low volatility,” he said. “Obviously they both benefit when volatility is low, but that is the only thing they have in common.”
As the name implies, volatility targeting aims to hold volatility at a specific level, allocating funds based on asset volatility. When volatility jumps, more volatile assets get sold as the fund moves into less volatile holdings. When volatility falls, the fund will load up on more volatile assets, potentially using leverage.
Risk-parity funds put together portfolios balanced by the risk of each asset class rather than according to percentages. They often use leverage to amplify the risk-adjusted allocation of less risky assets, such as bonds.
“There probably is some de-risking going on but nowhere near the magnitude of the VIX futures blowout,” Chintawongvanich said.
Analysts at Pavilion in Montreal said a Wednesday note that an increase in equity allocations by risk-parity funds since 2016 had helped them to weather some of fixed-income losses associated with rising reflation fears, but at the expense of making the strategy more cyclical.
As a result, they worry that a deleveraging of the strategy as a result of higher implied or realized volatility assumptions would leave equity markets “more vulnerable to sudden selling by these types of funds via a self-reinforcing mechanism.”
But Andrea Cicione of TS Lombard saw no sign that risk-parity unwinding was a culprit in the recent selloff.
“Risk parity indices have been flat since November 2017, while the S&P 500 was up 12%; exuberance in plain-vanilla equities, not risk parity strategies, is to blame,” he said in a Tuesday note.
Meanwhile, investors should expect higher volatility in the wake of the hiding taken by short volatility traders early this week, analysts said. The deleveraging of the short VIX ETPs should allow for a “normal” relationship between the S&P 500 and VIX to resume, wrote analysts at UBS.
They noted that “pair-wise” stock correlation has been near zero, which means that while stocks were volatile, their moves offset each other, depressing index volatility. As the market starts to move more in sync and the stock correlation rises, index volatility might rise more quickly than single stock volatility, putting upward pressure on the VIX.
MRA’s Chintawongvanich said that the lesson of the episode isn’t that it’s dangerous to short volatility, but that leverage can be dangerous—particularly when investors don’t realize how much leverage they are using, which he suspects was the case for many who had piled into short volatility products.
“My takeaway is that a major source of instability to the volatility complex is now gone. I don’t view it as the first tremor of an earthquake…The market has experienced a shock, but it has mostly absorbed that shock,” he said.