Saturday, July 2, 2016

Markets: The Rise of The Vol Tourists

Since the Great Financial Crisis, the volatility market has undergone some significant changes. One major driver was an increased awareness about tail risk hedging. This was further aided by increasing acceptance of volatility as an asset class. Following the correlation one period during the crisis, the trend among asset managers has been risk factors based investment, moving away from traditional asset class diversification. This, along with the rising popularity of exchange traded funds and exchange traded notes, has given rise to a whole new set of demands for volatility products as an asset class.

Another impact came via the central bank reaction function route. The profound changes and the new normal condition following the crisis brought in a new set of players ready to supply (short) volatility - including those so called "vol tourists". But the appeal of systematic short volatility strategy has been strong following the crisis. As the unprecedented monetary stimulus created a huge yield chasing pressure, shorting volatility has become an important source. I have written about this quite a while back from rates perspective, but this is generally applicable to any asset class.

The left hand side chart below shows why shorting volatility systematically has been so popular. This tracks performance of a strategy that shorts the nearest IMM VIX futures and rolls just before expiry. The size is determined to match a margin of 10% of the invested capital (the approximate worst case loss). After the crisis, apart from a few hiccups (notably during the 2011 US debt ceiling crisis), the performance has been quite impressive. 

The result has been a discernible dynamics in the VIX futures market. The right hand side chart above shows the typical nature of VIX positioning that we have seen in recent time.

On one hand we have the asset managers managing the various ETNs linked to VIX. The left hand chart below shows the flows in to such ETNs (the short VIX ones are added with sign, reflecting net flow in to equivalent long VIX funds). These flows have typically been negatively correlated with VIX level itself. And the positions of these asset managers in the futures market have pretty much followed these flows - as shown in the right hand chart.

This has led to a situation where dominant players are the swap dealers (large banks) and leveraged money managers - the hedge funds - either discretionary or systematic short vol players. In fact, given the fact that after the introduction of tighter regulations since the crisis, most of the swap dealers positioning will be driven by hedges. So this leaves the leveraged managers as the only discretionary players in the VIX markets. 

This particular development in volatility markets - fundamentally driven by ZIRP policy of central banks, new regulations and the paradigm of risk factor investing - has resulted in an overall low volatility and high contago environment, even over and above what one can expect with a central bank puts. Apart from the China fear back in Aug 2015, the VIX level has remained remarkably tamed - below 25 almost always. Also the spread between front month VIX futures and the VIX levels itself has widened significantly since the crisis, as the most discretionary players have been systematically short in futures. The futures curve has been so steep that it is now very costly for long players to systematically roll macro hedges in VIX futures. In a normal market in a mean-reverting asset class like volatility, you would expect just the reverse.

The second impact, arguably, has been the feedback loop to S&P itself. As we have seen above, the VIX funds are flow driven. This means the leveraged managers are short against the large banks. The fact that most banks will have a hedged position, especially after the new regulations, make this positioning quite asymmetric. For the short VIX players, it is a linear position in volatility. However for the swap dealers - the opposite long VIX position will also mean a short option position as hedge. It is not important whether the short option position is the trade and long VIX is the hedge or vice versa. What is important that, a long VIX positioning will also mean a short gamma position. And the act of delta hedging will feed this into the underlying, i.e. S&P. If most hedgers are short gamma, as the underlying moves and the hedgers buy or sell to re-balance delta, they will tend to amplify the move. On the other hand, if most of the hedgers are long gamma, their delta hedging will introduce a stabilizing effect on the underlying. And this is captured in the following chart.

The chart shows the 20 day correlation (kernel-smoothed to capture the trend) of S&P 500 opening moves vs trading hours moves. This can be treated as a measure of the gamma effect above. We can treat the opening move as an impulse from overnight news. If the day move tends to counter that systematically, it is highly probable that the long gamma dealers are introducing a stabilizing effect. This means you would expect to show this up as an accompanying short VIX position for the swap dealers under such condition. Whereas if the day move amplify the open, this points to a short gamma position of the street (long VIX). So this correlation measure should move in steps with swap dealers positioning if we are right. And as we can see this is indeed the case, especially since 2014.

For a few days prior-to UK referendum, you must have noticed this phenomenon in practice. Taking a cue from the European markets, the S&P would open down more often than not, only to recover and more almost with statistical consistency during the trading hours. 

The rise of the vol tourists (and the short vol players in general) means watching VIX positioning and tallying it with the underlying moves has now become an important input for investors, even if you have nothing to do with VIX itself.

all data from CFTC reports and Bloomberg

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