The recent equity market sell-off is believed to have been triggered, or at least exacerbated, by the high degree of short volatility positions in the market, which had taken the market value of two of the inverse VIX exchange-traded products (ETPs) to USD 3.2 billion by the end of January 2018 (see Exhibit 1).
Why had investors accumulated such large short VIX positions when almost everyone expected volatility to normalise eventually?
Exhibit 1: Inverse VIX exchange-traded product value
Source: Bloomberg, BNP Paribas Asset Management, data through 16/02/2018
There are two main reasons
- Explicit volatility-selling: Selling volatility can generate a yield which can boost income. This has been particularly attractive in an environment where interest rates are low, but even more so in the last few years of reasonable growth and low volatility across markets. This has encouraged investors to enter the short volatility trade in ever greater numbers and value given the excellent risk-adjusted returns it had been making until the spike in the VIX.
- Implicit volatility-selling: Portfolio construction techniques that use risk measures to allocate capital (e.g. risk parity funds, volatility control products) are implicitly short volatility – they tend to sell equities as volatility rises since their risk models tell them to de-risk. This can add fuel to the fire of a sell-off: the more that equities fall the higher that volatility gets, the more these funds in theory need to sell to bring the asset allocation down to their target risk level.
Explicit volatility-selling to generate yield is probably the smaller part of the total outstanding ‘short’ volatility trade, but importantly, the trend in assets under management in both explicit and implicit volatility-selling strategies has been increasing significantly in recent years. This means there has been a build-up of short volatility positions in the market.
(VIX) volatility begot volatility
Investors have been increasingly concerned with the prospect of a return of inflation and what that might mean for bond yields, and ultimately equity valuations. On 2 February 2018, the average hourly earnings wage inflation measure in the US surprised to the upside. The equity market had already been soft that day, but the declines accelerated towards the end of the day, resulting in the largest one-day fall for many years. Volatility had been rising that day as dealers scrambled to buy back protection they had sold. The unusually large downside move in the market also likely started to trip some of the systematic fund triggers to start de-risking.
When markets re-opened the following Monday, selling pressure was evident from the outset, and with volatility rising, market liquidity for futures trading started to dry up. This liquidity withdrawal further added to the storm that was brewing: the main reason for the sharp acceleration in the VIX index  that Monday was that by then, volatility had risen high enough to force explicit short volatility exchange-traded notes (ETNs) to buy back so many VIX futures (at the close) to rebalance their exposure to the correct level that they pushed the VIX price even higher.
This became a self-reinforcing mechanism whereby the higher the VIX went, the more futures they had to buy back. Investors who had an allocation to a simple vehicle such as XIV (the Velocity Shares ETN short VIX product), saw that ETN’s NAV fall by 96% that day (this ETN has since been liquidated). Institutional investors who may have made small allocations to explicit short volatility products are likely to have seen much smaller losses (on those allocations) due to the construction of the indices they tend to use.
It is important to realise, though, that apart from the unwinding of the explicit short volatility vehicles, implicit short volatility portfolios are likely to be de-risking as well, with the natural selling pressure that entails. This could keep volatility elevated and markets choppy. By some estimates, the bulk of the required de-risking by trend-following strategies (such as Commodity Trading Advisers, or CTAs) and by volatility control strategies had been completed by the middle of the week of 12 February 2018. That said, the slower-moving risk engines in risk parity products may mean some residual de-risking pressure from them continues.
This would likely leave these portfolios at a fairly neutral risk allocation (neither very long nor very short equities), however, a further plunge in equity values could trigger some portfolios to start outright shorting the market, which could start a renewed wave of selling pressure.
VIX to settle down
However, this is not our base case: ultimately, we see the equity market and volatility moves over the last few weeks as a technical event – an extreme position unwind – rather than a shock to the good growth fundamentals that we expect will drive equity markets over the medium term.
We remain constructive on equities in the next six to 12 months. Indeed, we are pleased to see that investors interpreted the latest, higher-than-expected CPI data as a healthy sign of growth rather than a worrying sign. Markets rallied and volatility fell. We would expect the market to re-connect to its fundamental drivers in the coming weeks and months, with earnings growth driving equities higher, and the VIX settling down to a new ‘normal’ level of around 15, rather than the artificially low level of around 10 that was the case before the correction.
The CBOE Volatility Index, known by its ticker symbol VIX, is a popular measure of the stock market’s expectation of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange.