Hedge funds are selling volatility again
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Hedge funds are once again betting the US stock market will remain tranquil.
The volume of “short” positions in the Vix volatility index has climbed to the highest since late January, just before the implosion of several Vix-linked funds ripped through financial markets.
Investment groups are now net “short” over 53,000 futures contracts in Cboe’s Vix index, according to data from the US Commodity Futures Trading Commission on Friday.
Shorting volatility — in practice selling insurance against market turmoil to other investors — has long been a lucrative strategy, and produced eye-watering gains in 2017. But it unravelled in dramatic fashion in February.
Mounting turbulence wrongfooted several exchange-traded products that systematically bet against volatility, causing them to collapse and exacerbate the stock market turmoil at the time. The S&P 500 lost over 10 per cent from its January peak in one of the swiftest US equity market corrections in history, an event that traders dubbed “Vixmageddon”.
The CFTC positioning data for “non-commercial actors” indicates that hedge funds are once again dipping back into the short-volatility trade, despite the chastening lessons of February and concerns over monetary policy tightening and a gathering trade war.
The net short position in Vix futures revealed on Friday is the biggest since January 30, shortly before the volatility gauge ripped higher.
Shorting volatility remains a good strategy in the longer-run, according to Stan Verhoeven, a senior portfolio manager at NN Investment Partners.
“Selling volatility comes with significant short-term risks, however long-term gains should sufficiently compensate for future tail-risk events,” he said. “It is better therefore not to try timing the next tail-event, but rather take a long-term approach and manage the embedded risks by investing in a broader set of diversifying factors.”
The stock market has calmed down from the choppiness seen in February and March. “Realised” rolling 30-day volatility of the S&P 500 has fallen back to about 9 per cent, the lowest since the start of February, and the Vix index, which measures the implied future volatility of the S&P 500 through option prices, has sagged back to 12.8 points, the lowest since January 26. At the peak of the February mayhem the Vix index hit 50.
The volume of Vix trading has fallen from the levels seen in January and February, but remains robust at well over 5m futures contracts a month in March, April and May, according to Cboe data.
The restoration of the low-volatility environment of 2017 raises thorny questions about whether investors are once again complacent over the outlook, or if February’s mayhem was simply a blip in a longer-term decline in turbulence.
Many investors have attributed the surprising post-crisis market tranquility to central banks’ monetary accommodation. But the Fed has now been raising rates for more than two years — albeit cautiously — and has begun to trim its holdings of bonds acquired in the wake of the crisis. Moreover, European Central Bank officials this week said that it would end its own bond-buying programme by the end of the year.
Analysts at Morgan Stanley argue that shorting volatility at these levels does not produce enough income to compensate investors for the risks of more turbulence.
“Selling vol on equity, credit and rates looks quite challenging despite positive carry, unless one is very optimistic on the longevity of the cycle,” the bank said in a report earlier this month. “The low volatility environment we have been in means that positioning unwinds can still feel very painful.”
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