by STEPHEN GANDEL
The best thing you can say about sudden market drops is that they can point out the market’s weaknesses and create a road map for regulators to clean up any excesses. The bad news is that regulators look increasingly uninterested in protecting investors from the market’s potholes.
So, on Tuesday, while it was still hard to know what was propelling the market’s decline — rising interest rates, inflation fears — it was pretty clear what had made the market’s drop worse: Volatility indexes and the billions of dollars tied to them.
It wasn’t supposed to be this way. The CBOE’s Exchange Volatility Index, commonly called the VIX, was supposed to make the market less volatile by giving investors a better picture of the possibility of a stock drop and the ability to hedge against it. Instead, Wall Street did Wall Street and managed to produce the opposite outcome — the index that was supposed to smooth out volatility has made it worse.
Few people knew about the VIX in 2008, when it soared during the financial crisis to just over 80 from 16 in just six months. But since then, investors, always on the look out for things that go up, particularly when everything else is going down or sideways, have wanted in, and Wall Street has complied, creating all measure of pro-ducts that allow investors to bet on the VIX’s direction. Through last October, investors had poured some US$15.5 billion (RM60.52 billion) into the three largest exchangetraded products (ETPs) tied to volatility.
And they are tied not just to volatility but are particularly leveraged to big swings in volatility. The VIX is really a measure of the perceived chance of big moves in the market.
So, during the financial crisis, the VIX rose 64 percentage points. On Monday, the VIX rose 20 percentage points to 37 percentage points from a close of just over 17 last Friday. But that’s not the same as offering an investment product that shoots to 37 from 17 in a day.
So, Wall Street came up with VIX funds that just bet on changes in short-term volatility and rebalance those bets daily to give investors as close to that 116% change in the value as possible. But the biggest boost in the volatility complex may have come from so-called risk parity funds, which promised to create diversified portfolios by spreading assets based on volatility rather than say a traditional 60-40 stock-bond mix. A research paper published in November put the current size of the volatility investment complex, which really didn’t exist in 2008, at about US$1.5 trillion.
All of this appears to have once again proved the observation effect. The act of measuring volatility has exacerbated the swings of both the VIX and the market. During 2008, when it looked like financial markets would collapse, the VVIX index, which measures the volatility of the volatility index, peaked at 135.
In late 2015, when a drop in oil created a much smaller crisis in the high yield market, VVIX rose to 168. On Tuesday, at a time when the economy by all measures other than the market is just fine, the VVIX hit 180.
This has created a pretty big mess. The relatively smooth climb of the market over the past few years has resulted in not just a low VIX but a historically low one. That signalled there was little to fear, and more people bet on the VIX staying low in a surprisingly lucrative trade.
It looked like a can’t-lose proposition, so, of course it did. Stocks dropped, and all of those low volatility bets had to be unwound, effectively causing forced buying, which is why the VIX soared on Monday and Tuesday morning, at one point reaching 50.
That will force risk parity funds to sell stocks, which all of a sudden look a lot more risky according to the VIX but most likely were just as risky all along. Much of the investment products that Wall Street created to bet on volatility have been losers.
Even before Monday’s swings, investors had lost nearly US$14 billion on volatility funds since 2009. Monday’s swings appear to have wiped out plenty more.
On Tuesday, Credit Suisse said it was liquidating its VelocityShares Daily Inverse VIX ShortTerm ETN, and more than a dozen VIX-related ETPs have been suspended. The Credit Suisse fund had about US$2 billion invested in January. Much of that appears to have been wiped out.
And the pain in VIX land isn’t over. Goldman Sachs predicted on Tuesday that much of what was betting against the VIX had been wiped out on Monday and that VIX investors were now betting heavily on a jump in the VIX, just in time for the VIX to fall on Tuesday.
Given all this, you might think regulators would have taken a hard look at volatility funds already. They have barely dipped their toe in the water.
In October, Wells Fargo & Co (big surprise there) was fined US$3.4 million by Wall Street regulator Finra (Financial Industry Regulatory Authority Inc) for pushing volatility-linked investments. It called the investments unsuitable for many of the individual investors that Wells Fargo had sold them to. But that has done little to stop the sales of volatility investments broadly.
This is exactly why the Consumer Financial Protection Bureau (CFPB) was created under the Dodd-Frank overhaul law, to shield investors from inappropriate products and shoddy practices and police markets that could give rise to financial instability more broadly. Many of these volatility funds were marketed to individual investors and would seem fertile ground for the CFPB.
But don’t hold your breath waiting for it to spring into action. The bureau’s acting director, Mick Mulvaney, said recently the organisation would no longer push the envelop. Reaching out to regulate exchangetraded funds would most certainly fall in that category.
Another regulator created by Dodd-Frank, the Financial Stability Oversight Council, might also be expected to take a hard look at volatility funds. But it is headed by Treasury Secretary Steven Mnuchin and has not signalled any desire to be aggressive about much of anything.
The market’s tumult in the past few days has provided a hint of the risk posed by volatility funds. Regulators are not at all inclined to take it, meaning the volatility complex will continue to grow, with the potential for real danger growing along with it. — Bloomberg
- This column does not necessarily reflect the opinion of Bloomberg LP and its owners.