Well, it finally happened. The short volatility trade blew up and the volatility genie is now out of the bottle. Credit and monetary conditions are still extremely loose so this should calm down soon, but I doubt we see a low volatility regime like 2017 in a long time.
So here’s what happened: Two Inverse VIX ETP’s (exchange traded products) blew up Monday night with both losing over 90% of their value. They were the Credit Suisse VelocityShares Daily Inverse VIX ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY). Credit Suisse decided to terminate the XIV product since, being an ETN, it’s a liability of the firm and doesn’t actually hold any assets within a fund. ProShares is apparently letting SVXY continue to trade. It’s important to note that these didn’t cause the stock market to fall but the unwind has exacerbated the movements.
These products were basically identical in their strategy of shorting the VIX futures curve (“shorting” or “going short” means you make money if it goes down and lose money if it goes up). Since the curve is upward sloping, you continually earn a premium each month when the front month matures and you “roll” the position 3 months out and sell at a higher price. The problem with this type of strategy is that it’s akin to picking up nickels in front of a steam roller. It works really well… until it doesn’t. It was a mathematical certainty that these products would eventually blow up if short-term volatility ever spiked high enough in a single day. And it did that on Monday. I wrote about this about a year and a half ago in a post called “The Next Market Fad to Blowup,” highlighting how much money was pouring into these related funds and strategies betting on short volatility. There was billions in these products alone, and that doesn’t even scratch the surface of how much money is managed in a similar manner through all sorts of various risk parity and short vol funds which Artemis Capital estimates is (was) roughly $2 trillion. Only time will tell how many hedge funds and banks paid a steep price on this trade. I also wrote last year how these funds were compressing volatility which led risk parity funds to buy the stock market in a “tail wagging the dog” effect. Now that this money isn’t out there crushing the VIX, stocks are having a hard time finding a bid.
The saddest part is that a lot of retail investors lost money on these. There’s an important lesson here for anyone that participates in the investment markets to understand: if there is demand for something, Wall Street will find a way to conveniently package it into a product and sell it to you. Just because Wall Street makes it easy to buy, doesn’t mean it’s safe, smart or a good investment. In fact, if it seems to good to be true, it is. This is uncomfortably reminiscent of 2007 with all the subprime mortgage funds.
Big time funds have been using these strategies of selling volatility as a way of generating yield because rates are so low. Here’s a list of the top holders of SVXY:
Harvard?? Why did Harvard own this in their endowment fund? I think this shows how desperate the investment world has become for yield and it makes me think that the next market that’s going to get hit is the junk bond market. Credit spreads are still insanely tight and the market has been ignoring the fundamentals for almost 2 years now, courtesy of ETF fund flows. Leverage ratios continue to rise but defaults have remained low because easy money through ultra-low rates and trillions of Central Bank QE has been a lifeline to struggling companies. Mind the gap…
This is also why, in my opinion, active fund managers have continually underperformed the index and especially so if they utilize a value approach. High leverage will supercharge the equity of a company, meaning their stock goes up a lot when things are going well but will get absolutely crushed when things turn against them. The next chart says it all. The gray line is basically a leverage ratio, showing net debt-to-EBITDA. The blue line shows the ratio of relative performance of Strong vs Weak balance sheet companies. These metrics have always tracked each other closely… until the central banks started QE. What this essentially shows is that since 2010, the more debt a company takes on, the more their stock goes up. Just more of the weird distortions and unintended consequences affecting the markets and economy.
I sincerely hope no one following this blog owned those inverse VIX products (my clients certainly did not). I don’t mean for this post to be a “I told you so” type of post either. I’m trying to educate and inform. The reason I point out so many risks is because that’s the key to successful investing – avoiding the losses. And this is the type of market where big losses (permanent impairment of capital) are possible. All of this sends the same message to me: now more than ever, it’s vitally important to understand what you own and why you own it. “Because it’s going up” is not a good reason.
-Nick