Market Volatility: "The reports of my death are greatly exaggerated."

I started drafting this piece a week or so back when the VIX first closed in the single digits. When CNBC and Bloomberg TV, cover on a daily basis the phenomenon of volatility being low, we are probably close to the end rather than the beginning.

Why has VIX been so low? Should it be this low? Will it stay there?

The VIX is calculated using a "formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls." There's a pretty complicated paper on the exact calculation (read it here).

There are a couple of ways I personally think about the VIX - we can talk about whether that's right or wrong in the comments below (would love some feedback - I do not profess to be an expert).

To me, it measures fear and greed (and with greed, comes complacency). In addition, the VIX is a numerical representation of supply and demand levels for S&P options.  From where I'm sitting, there looks like there are a lot of option selling.

I was just speaking with a fund that has done well enough in the discretionary macro space, and all of a sudden, they want to get involved in selling vol. Obviously, retail is in on this as well, evinced by the myriad of short VIX ETFs in existence. I know, I know. Anecdotal signs. But to me, they point to one thing:

Contributor James posted on Macro Man a few months back with some insights on the VIX, looking at various rolling correlations and momentum numbers - I don't know if looking at momentum and price dislocations, etc. for the VIX makes particular sense. With that said, there are definitely some points of insight and interests in his post. Go ahead and check it out.

I wanted to think about what could be contributing to the drop in market volatility.

Two factors in play, contributing to the suppression of volatility and its subsequent unwind are the following.

Passive investment/Indexing:

It's well documented that there has been huge flow into passive investment in favor of its active counterpart. However, the performance and subsequent investment flow from active to passive follow a clear cyclical pattern, as you can see in the picture below.

It's been well documented that we are currently in the midst of a historical shift towards passive buy and hold investment.

This is where are we now looking at relative performance:

I have noticed some reflexivity (à la George Soros) characteristics in this shift:

As volatility drifts lower, the more passive investment out performance, as passive investment out performance, money flows out of active management to passive investment, thus helping to suppress volatility.

Reflexivity is dual sided. This positive feedback loop that has helped quell volatility, can easily be unwound in the other direction as well in violent fashion (selling begets selling).


Risk Parity Funds/General Vol Targeting Funds:

Another factor that could lead to large increases in equity and fixed income is the rise of the myriad of risk parity funds.

These are just a portion of the risk parity funds that currently exist in the market

Without going into a deep dive of risk parity funds (maybe we'll save the fun for some other time), I just want to highlight a couple of risk parity funds' characteristics that can lead to a unusual large sell off in the assets these funds own.

First, there are a lot of money implementing the same strategy. Doesn't take a genius to figure out that things can go bad quickly if everyone is trying to escape a burning theater at the same time.

But what can lead to such an exodus? These funds are volatility targeted and implement similar draw-down types of risk controls.

What are draw-downs? Think stop-loss but on an entire fund level instead of one particular position. When are draw-downs implemented? When the fund volatility exceeds a certain preset level (fund volatility roughly calculated via the volatility of the composite assets). With that said, it's to see how a large enough exogenous shock to a specific market, can lead to a large continual spike in volatility and draw down in a number of markets.

In addition to risk parity funds, there are also a lot of smart beta funds and other quantitative investment funds that have specific hard volatility targets. Again, they are bound to sell if volatility hits a specific number; their backtests are skewed to the low end of volatility as the recency of the current low volatility environment unrealistically skews their data towards underestimation.

Should volatility be this low?  Will it stay here?

Should it be this low? Probably.

All the reasons, I've mentioned above probably shows you why volatility should be this low. However, as speculators, we are worried about the world in the future, not in the present.

So what about the future?

We have a deterioration of some of the US macro data, the Fed continuing marching on in terms of hikes, the geopolitical risks in terms ofSyria and North Korea, and the circling of political vultures over the Donald Trump's scandals du jour.

There is a copious amount of risks simmering under this low volatility market surface, that can trigger be the exogenous shock.

A conjecture on how this ends:

Oh, the humanity!

Pretty sure most of us know this, just a question of when.

I can't predict when, I can only advocate insurance.

If you own a house, that's your asset, you buy insurance on it. If you own a portfolio, that's an asset, why don't you buy insurance on it? Besides, insurance is cheap.