Volatility & the Alchemy of Risk
Another day, another positive closing day for the stock markets as equities edge ever higher in a seemingly never ending streak of higher closes with no meaningful pullbacks, stretching as far as the collective memory can retrieve.
The apparent calm and steadily rising markets in the past years have ushered in a new – and very profitable so far – trading strategy: low volatility or a set of strategies based on the assumption that volatility of the underlying asset classes is going to stay low (in other words, short volatility). Short volatility (or short vol) investment strategies come in many forms, the most visible of which to retail investors are the exchange traded VIX instruments, personified by the fabled ex-Target employee who quitted his daytime job and made millions day-trading VIX ETFs.
The short volatility trade has grown so immensely popular that an estimate of $2+ trillion is involved in this strategy in one form or another.
What could possibly go wrong with this trading strategy?
More importantly, what impact would it have and what systematic risks could it bring to the global markets should this strategy fail or unwind?
A recent analysis from Artemis Capital Management offers a deep dive on this mushrooming global short vol trade. The report named Volatility and the Alchemy of Risk takes an in-depth look at the driving forces giving rise to the short vol frenzy, the different types of short vol trading strategies and the inherent risks associated with these strategies. It is a must read for any market participant who wants to anticipate and position himself for the next major market move.
In the world of short vol, short VIX ETFs, which garner the most media attention, are only the tip of the iceberg. There is a huge amount of trades structured that are implicitly short vol and deployed across many asset classes in addition to equities.
The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility.
Short Volatility Defined
A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. The trade resembles a snake eating its own tail. Artemis:
A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability. The investment ecosystem has effectively self-organized into one giant short volatility trade, a snake eating its own tail, nourishing itself from its own destruction. It may only take a rapid and unexpected increase in rates, or geopolitical shock, for the cycle to unwind violently. It is unwise to assume that central banks will be able to respond to future financial stress with more stimulus if inflation is rising.
Driving Forces behind Short Volatility
The global short vol phenomenon owes its origin to the central banks which since 2009 have injected $15 trillion in stimulus under their misguided monetary policies and created a substantial imbalance in the demand for and supply of quality assets. The tsunami of credit crushed interest rates to the lowest levels in human history, with $9.5 trillion worth of negative yielding debt globally.
The state sponsored financial terrorism that is the zero/negative interest rate policy (ZIRP/NIRP) created global herds of yield starved ZIRP refugees. They scour every corner of the globe searching for yields, any extra yield regardless of the accompanied risks, to meet their investment mandates.
The ultra low interest rates also allow corporations to engage in financial engineering. Instead of going through the traditional hard work of spending capex to improve their products and capacity, corporations simply use most if not all of their earnings and then borrow some more to buy back their shares in order to make their financial performance metrics look good. Collectively, they spent $3.8 trillion buying back their own shares, contributing to the further lowering of volatility.
Amid this mania for investment, the stock market has begun self-cannibalizing… literally. Since 2009, US companies have spent a record $3.8 trillion on share buy-backs financed by historic levels of debt issuance. Share buybacks are a form of financial alchemy that uses balance sheet leverage to reduce liquidity generating the illusion of growth. A shocking +40% of the earning-per-share growth and +30% of the stock market gains since 2009 are from share buy-backs. Absent this financial engineering we would already be in an earnings recession. Any strategy that systematically buys declines in markets is mathematically shorting volatility. To this effect, the trillions of dollars spent on share buybacks are equivalent to a giant short volatility position that enhances mean reversion. Every decline in markets is aggressively bought by the market itself, further lowering volatility.
Volatility asset classes
Whereas the global short volatility trade is practiced across a large swath of asset classes, the report delves into the US equities market and further breaks down short vol into explicit and implicit short volatility strategies.
Explicit short volatility are strategies which bet on falling/stable volatility or falling market variance by selling options to capture the premiums. Though receiving the most attention and media headlines, explicit short vol strategies amount to roughly $60 billion in assets and represent only the visible portion of the proverbial short vol iceberg. Artemis’ description of explicit short vol strategies:
Explicit Short Volatility are strategies that literally sell options to generate yield from asset price stability or falling stock market variance. The category includes everything from popular short volatility exchange-traded-products to call and put writing programs employed by pension funds. Despite the headlines, this is the smallest portion of the short volatility trade. Explicit short volatility contains upward of only $60 billion in assets, including $45 billion in short volatility pension put and call writing strategies , $8 billion in short volatility overwriting funds , $2 billion in short volatility exchange traded products, and another $3 billion in speculative VIX shorts . Explicit short volatility strategies are active in the short term, fading short and intermediate volatility spikes. Volatility spikes that mean revert quickly help the performance of these strategies (August 2015). Explicit short volatility is most harmed by an extended period of high volatility that fails to mean revert, such as in 1928 or 2008, or a super-normal volatility spikes such as the Black Monday 1987 crash.
Instead of directly selling options, implicit short volatility are strategies which use financial engineering to generate excess returns by exposure to the same risk factors as short option portfolio. Artemis:
Implicit Short Volatility are strategies that, although not directly selling options, use financial engineering to generate excess returns by exposure to the same risk factors as a short option portfolio. Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure, including between $400 billion in volatility control funds, $400 to $600 billion in risk parity, $70-175 billion from long equity trend following strategies, and $250 billion in risk premia strategies. These strategies are similar to a short option position because they produce efficient gains most of the time, but are subject to non-linear losses based on variance, gamma, rates, or correlation change. The strategies tend to have longer time horizons for rebalancing than explicit short volatility. In practice, exposure to equities is reduced based on the accumulation of variance over one to three months.
Hidden, Non-Linear Risks
Both explicit and implicit short vol strategies are subject to the following hidden, non-linear risks.
- Gamma risk – whereas an explicit short vol strategy of selling options is subject to an inherent short gamma risk (for those non-option geeks, gamma measures the rate of change of delta which tells us how much an option price will change given a one-point change of the underlying. I know I know. In plain English, the rate of change is not linear and gets increasingly bigger the closer the strike price gets to be at the money. (see gamma definition). Whereas an explicit short vol strategy of selling option is subject to an inherent short gamma risk of which every option seller should be well aware, other portfolio insurance strategies, risk parity, volatility targeting funds, and long equity trend following funds all bear synthetic gamma risk in that they are forced to deleverage non-linearly into periods of rising volatility. At current risk levels, an estimate of $600 billion in selling pressure would emerge from implicit short gamma exposure if the market declined just -10% with higher vol.
- Correlation and Interest Rate Risk – The concept of diversifications espoused in modern portfolio theory is widely deployed to reduce risk of a portfolio by combining anti-correlated assets, and correlation risk is isolated and actively traded via options (short correlation) as source of excess returns. These strategies are effective when correlations are stable or decreasing, but will incur large losses when correlations behave erratically.
- Volatility risk – short vol VIX products have become the get-rich quick scheme for many retail investors. Short and leveraged volatility ETNs contain implied short gamma requiring them to buy (sell) a non-linear amount of VIX futures the more volatility rises (falls). The risk of a complete wipeout in the inverse-VIX complex in a single day is a very real possibility given the wrong shock.
- Shadow risk in passive investing – By the start of 2018, 50% of the assets under management in the US will be passively managed. In a market without value, passive investing is just a momentum play on liquidity. The shift from active to passive investing is a significant amplifier of future volatility.
- Shadow risk in machine learning – trading is increasingly dominated by machines armed with AI based machine learning with the vast majority of the historical data from which to learn generated from the past few short years. With most of these machine algorithms biased toward leveraged short volatility trades which have been highly successful in recent years, the chance of one or more of these machines failing spectacularly is significant when the volatility regime shifts.
Volatility Regime Change Trigger
One natural and likely cause for a wholesale change in the volatility regime would be the credit cycle. The credit cycle, as Artemis puts it, is the brother of volatility:
Volatility fires almost always begin in the debt markets. Let’s start with what volatility really is. Volatility is the brother of credit… and volatility regime shifts are driven by the credit cycle. Volatility is derived from an option on shareholder equity, but equity itself can be thought of as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.
Although the credit stress needed to drive the dramatic expansion of volatility is presently not present, storm clouds are certainly gathering heading into 2018: rising interest rates, historic high valuations, deteriorating corporate balance sheets combined with a mountain (estimated $134 billion) of high yield debt needing to be rolled-over in the next two years.
With similar credit conditions in play, Black Monday in 1987 serves as an eerie reminder of how a credit fire can turn into a volatility explosion.
First the fire, then the blast… In 1987 portfolio insurance was a popular strategy ($60 billion in assets) that involved selling incrementally greater amounts of index futures based on how far the markets fell. The WSJ ran an article on October 12th that warned portfolio insurance “could snowball into a stunning rout for stocks”. Nobody paid attention.
Although equity markets continued to rise into the summer, the credit markets began to suffer from a liquidity squeeze. The spread between interbank loans and Treasury Bills spiked 100 basis points in the month of September alone, and then rose another 50 basis points in October leading up to the crash. Corporate yields exploded 100 basis points the month leading up to the Black Monday crash, increasing of over 200 basis points since earlier in the year. By the late summer the equity markets got the memo. Between August 25 th and October 16 th, the S&P 500 index fell – 16.05%. S&P 100 volatility moved from 15 in August to 36.37 on October 16 th . That was just the beginning.
On Black Monday the market lost one fifth of its value and volatility jumped to all-time highs of 150 (based on VXO index, predecessor to the VIX index). In total, from August to October 1987 the market lost -33% and volatility exploded an incredible +585%. Black Monday is best understood as a massive explosion that occurred within a traditional fire. Rising inflation started a liquidity fire in credit, that spread to equities, and reached the nitroglycerin of computerized trading before exploding massively. Central bankers were not able to cut rates at the onset of the crisis to stop the fire due to rising inflation. The same set of drivers exist today, but on steroids. Higher rates combined with $1.5 trillion in self-reflexive investment strategies are a combustable mix. It is important to realize that the 1987 Black Monday crash was comparable to any other market sell-off until it wasn’t. The only difference… in 1987 volatility just kept going higher and markets lower. [The chart above] shows the movement in volatility leading up to crises in 1987, 1998, 2008, 2011, 2015. The point is that if you are a volatility short seller, how do you know whether you will get a 2015 outcome, when markets rallied, or a 1987 outcome? You don’t! In 1987 inflation started the volatility fire, but program trading amplified that fire into a cataclysmic conflagration. The $1.5 trillion short volatility trade, in all its forms, can play a very similar role now if rising inflation causes tighter credit conditions, but also limits central banks from reacting.
In conclusion, the report predicts that, with fixed income volatility at all-time lows at a time when the Federal Reserve is raising rates, active long volatility and stocks will outperform over the next five years.
Again, here is the full report: Volatility and the Alchemy of Risk.