Betting on Higher Vol

October 31st, 2016 6:05 am | by John Jansen |

Via WSJ:

Wall Street’s bet against fear, a big winner this year, is starting to wane.

The relative calm in the U.S. stock market has made wagering on a decline in the CBOE Volatility Index, or VIX, a popular trade for much of this year. The two biggest exchange-traded funds that short volatility, as betting on a decline in the VIX is known among traders, are up 46% this year. Hedge-fund bets that the VIX will decline reached a record in September, according to data from the Commodity Futures Trading Commission.

“These strategies have had a pretty significant up year,” said Rocky Fishman, equity-derivatives strategist for Deutsche Bank. “Those positions make money most of the time, but they lose money very quickly when volatility rises.”

Lately, investors seem increasingly worried about that outcome.

The VIX, a measure of traders’ expectations for market swings, climbed 5.4% Friday after the Federal Bureau of Investigation announced that it was reviewing new evidence in the investigation of Democratic presidential candidate Hillary Clinton’s email server, a probe that the FBI had closed this summer. The news sparked worries about a surprise election outcome after polls had shifted toward Mrs. Clinton in recent weeks and traders had been positioned for a muted response to the outcome of the Nov. 8 vote.

Even before then, hedge funds had been paring their short bets. Since early September, short bets on volatility futures are down by 21%, CFTC data show. And flows into and out of exchange-traded funds indicate expectations for greater volatility. In the month ended Oct. 25, $822 million flowed into ETFs that profit when volatility rises, while $326 million has been pulled out of the shorts, according to FactSet.

The adjustment could reflect concerns about two upcoming potentially market-moving events—the U.S. presidential election and a possible interest-rate increase. The Federal Reserve isn’t expected to raise rates at its November meeting this week, but may send a signal about its plans for December.

The interest in trading volatility also shows the rise of the VIX as an asset class. Since the VIX tends to soar when stocks tumble, betting on volatility to rise—called going long—has emerged as a popular way to protect portfolios.

 

The advent of volatility ETFs in 2009 increased the appeal. The funds can be bought and sold like any other stock, allowing investors to bet on the VIX without trading futures and options directly.

Using volatility as portfolio protection comes at a cost. Because uncertainty increases with time, the further away an anticipated downturn is, the more expensive it is to insure against. That means VIX futures for this month are typically cheaper than next month’s contracts, which are cheaper than the month after that, and so on.

That forces most buyers to pay a premium to maintain their insurance. It is especially draining for the long exchange-traded funds that seek to profit from rising volatility. Some of the funds maintain their exposure through a combination of this month’s VIX futures and next month’s. Every day, they sell contracts that are nearing expiration and buy contracts for the following month. Put simply, the ETFs that are long volatility sell low and buy high, almost every day. The largest such ETF, the iPath S&P500 VIX Short-Term Futures ETN, has declined 58% this year.

This creates an opportunity for the hedge funds and short ETFs that sell the insurance and take the opposite side of the trade. They will profit when the VIX declines. But even if volatility is relatively flat—and sometimes even if it rises—sellers still take their cut, buying low and selling high. That premium is why the trade has been so reliably profitable.

Shorting volatility has drawn interest in recent years because unconventional central-bank policies have calmed markets, enticing investors to try to boost returns through the trade.

But shorting the VIX can amplify losses in a stock-market downturn. For every percentage-point gain in volatility futures, hedge funds stand to lose $163 million on short bets, CFTC data show. The day after the U.K.’s surprise vote to exit from the European Union, the S&P 500 fell 3.6% and the VIX spiked 8.5 points. The two biggest short-volatility ETFs lost a quarter of their value, although the losses later reversed.

Systematic volatility sellers aim to collect the premium, and take measures to protect themselves against such brutal reversals. The San Bernardino County Employees’ Retirement Association uses options to buffer downside exposures, said Don Pierce, the chief investment officer.

 

“I worry every day about my positions and I worry about my hedges, but I believe in a systematic approach so you don’t have to make decisions in the middle of a market panic,” said David Pedack, a portfolio manager at Russell Investments.

The severity of the post-Brexit losses came as a shock to Bryan Sullivan, chief executive officer and managing partner of WealthSource Partners LLC. WealthSource, an investment advisory firm in San Luis Obispo, Calif. that manages more than $600 million, bought 76,000 shares of the ProShares Short VIX Short-Term Futures ETF shortly before the vote. It was a new strategy for WealthSource, which saw its investment plummet 26% in hours, Mr. Sullivan said.

“Brexit was a good example where we got hammered for a few weeks,” Mr. Sullivan said. “It was a big question: Are we sure we want to be doing this? We had some deep conversations about it, but we decided let’s wait this out.”

The ProShares ETF recovered its post-Brexit losses within a month, and is now 25% higher than it was the day of the vote. Mr. Sullivan said, though, that he has since bailed out because of worries about rising volatility amid election-year uncertainty.

“A lot of things could drive volatility higher through the end of the year,” Mr. Sullivan said. “So being short is not necessarily the right place to be.”

Write to Asjylyn Loder at asjylyn.loder@wsj.com

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