The Short-Vol Trade: Someone Forgot to Turn Off the Machine

Equity markets took a standing-8 count over the weekend and came out swinging on Monday, bouncing roughly 1.5% off the lows from Friday’s close, and a solid 4-5% off the spike bottom lows around lunchtime.

Friday’s headlines were notable given the change in sentiment--a correction!  To again quote Matt Levine at Bloomberg….”there you go. All you’re stock prices are correct now.” The rest of the financial media howled in unison.

It wasn’t a contrarian green light, but it was close. Buyers had a few strong points in support:

• On the technical side, there’s little doubt a significant portion of the price action last week was driven by some combination of forced selling, negative convexity, liquidity seizures, and outright panic.  
• Fundamentally, no change, and notably cheaper valuations:
• still strong global growth, 
• A weak USD
• Strong commodity prices
• Fiscal stimulus in the US
• A new Fed chair that has pledged fealty to the credit-addict that gave him the job
• Moreover, central banks that recognize the fragility of the beast they birthed

It adds up to a decent opportunity to buy...if you didn’t get run over making the same call at some point last week. I’ll let y’all duke it out in the comment section on that one. It is the last point that has been bothering me all week.

An astoundingly quiescent market, followed by higher rates and a modest risk-off move in stocks, contributed to a MOAB move in vol, gamma and the VIX. Usually when something like this happens--and it is supposed to happen periodically--vol everywhere spikes higher, FTQ assets appreciate, and the system rebalances itself.

What is not supposed to happen is something like this:

So what’s going on? There’s been no shortage of media coverage on the blowup of short vol ETNs like XIV. But as I highlighted last week, these products are--or were anyway--$2-4bn in notional value in a market that is many, many times that size.

The real iceberg beneath the surface is the short-vol trade writ large. The short-vol trade goes by a few different names--last October, in an article highlighting the depths of the short-vol monster, Chris Cole at Artemis Capital Management illustrated it as a pyramid:

Cole called this the Ouroboros, the mythical greek snake that devours itself by eating its own tail.

“Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield….A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all, of these risks even if they are not explicitly shorting options….Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability. Investors assume increasingly higher levels of risk betting on the status quo for yields that look attractive only in comparison to bad alternatives.”

Put another way, as the avalanche of monetary stimulus compressed risk and pushed down expected returns, Wall Street needed a new asset class to sell in the search for yield. Pension funds needed to maintain high returns, and were ready to listen to the sales pitch for volatility as an asset class.  

Let's look back a couple of years for some examples of how this was sold to investors. Pimco led the charge in 2012 with this article entitled, “The Volatility Risk Premium.”

“We conclude that the risk-return tradeoff for volatility strategies compares favorably to those of traditional investments such and equities and bonds and that the strategies exhibit relatively low correlations to equity risk.”

Ooh, now you have my attention, says Joe Capital-Allocator at XYZ Pension Fund, tell me more.  All too happy to oblige, Pimco continues:

Well there it is...implied vol is typically higher than realized vol. Real MIT rocket science PhD type of stuff. There is a good rationale and justification for that “premium” that is not unlike an insurance premium. Though I wouldn’t call it that, since realized and implied volatility really don’t have a relationship other than one that is backward looking.

Yes, there is a “price” there. What’s the right price? Think back to 2012--in the article The Pimco authors concluded, “given the economic rationale for the existence of a volatility risk premium, and the supportive supply-demand situation that emerged following the 2008 financial crisis, we believe an allocation to volatility strategies could enhance portfolio efficiency.”

I’ll bet they did….but they were right! Back in 2012, there were no shortage of Black Swan disciples of Roubini and Taleb pitching and building tail risk products and funds. The memories of the GFC were still fresh, and the wounds were still healing. If that weren’t enough, the entire European project nearly imploded on itself, giving more ammunition to those that believed the financial system was on a steep descent into (further) chaos. It comes back to recency bias...The demand for volatility was high. The short-vol trade was born to provide the supply...and fees!....to support it....and yield-hungry institutional investors ate it up.  It was a good trade if you had a long-term time horizon and didn’t think the world was about to end.

The trouble is, someone forgot to turn off the machine. By 2015, Nomura was pitching a product they called the eVRP--the Equity Volatility Risk Premium-- all backed by a Nomura index that followed this kind of thing. As prices rose, financial engineering took over for thematic simplicity.    

Now, this wasn’t just a diversifier, it was some sexy stuff! Check out these charts:

The volatility risk premium has been a great trade compared to “long only”

Selling equity vol risk premium is when vol is low...your road to a 2.0 Sharpe

The equity vol risk premium is better than ya know, other stuff

All the cool kids are doing it

Three years on from the Pimco article, when there was a tasty volatility premium thanks to the back-to-back existential crises in global markets, Nomura is pushing the same trade, only in the form of their esoteric eVRP product rather than the more straightforward Pimco strategies of 2012. And of course, Nomura has the data to back it up, and your friendly salesman has just the right product for your long-term risk bucket.

This is the Ouroboros. Just like the housing/credit bubble in the mid-00s, the financial system doesn’t know how to stop. Just because there was a rich volatility premium in 2012, doesn’t mean it is perpetually and always going to exist. In fact...quite the opposite. As markets calmed, the trade worked….and more money flowed into it. Supply and demand swung the opposite direction, but nobody ever turned off the machine.

The snake latched on to its own tail, compressing vols, perpetuating BTD, which compressed vols, which juiced returns. Lather, rinse, repeat. And wait for the bonus checks to roll in.

How can you identify when this trade is overdone? You can probably point to your own examples, but these two charts sum it up:

You’re telling me there’s an equity volatility premium….even as equity vol its generational lows?

That can only be because you’re looking at realized vol still below implied vol. That’s what you call a “premium”?

Then in fixed income….monetary authorities are finally hiking rates and decreasing or stopping asset purchases….and you think you can capture a “premium” for volatility above realized when implieds (as proxied here by 1m/10y USD swap vols) are THIS far below the long-term average?  

(I trimmed this chart back to the lows in January before the spike in the last two weeks to illustrate the point, but the current level stands just above 80)

As Cole said in the “Alchemy of Risk” article...as the short-vol sales machine perpetuated itself, it gave birth to a reflexive process:

“What we think we know about volatility is all wrong….Modern Portfolio theory conceives volatility as an external measurement of intrinsic risk of an asset….this highly flawed concept, widely taught in MBA and financial engineering programs, preceives volatility as an exogenous measurement of risk, ignoring its role as both a source of excess returns and as a direct influencer on risk itself. To this extent, portfolio theory evaluates volatility the same way a sports commentator see hits, strikeouts, or shots on goal. The problem is volatility isn’t just keeping score, but is massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. “

That’s what has changed...Pimco and Nomura built their analysis on a history where volatility was a measure. Now it is a player. It has a price. What once was rich is now obscenely expensive.

Yet for these guys it all comes back to returns--more specifically risk-adjusted returns.   How did the Nomura guys fair at selling volatility?

This is the stated performance of their “eVRP” product as of January 25:

12-month excess return of 4716 basis points! A 1yr sharpe ratio of 3.74! As Kevin Muir at MacroTourist said back in November in a post on the same subject, “Hedge fund managers do terrible unspeakable things for Sharpe Ratios of 2.5 to 3. Indeed...and pension fund investors are no different. Moreover, that 5-yr Sharpe of 1.28 is pretty spicy too when compared to the Sharpe on long-only equity returns skulking on either side of .5.

Now, fast forward to last Thursday:

Oh dear. Our precious short-vol baby vaporized that 1yr excess return in only two weeks! And those Sharpe ratios went from heavenly to downright ordinary, and I’ll hazard a guess that these figures aren’t including the tasty fees that your pension fund paid their friendly neighborhood bank or hedge fund for managing this risk over the past few years.

It started as a good trade...but as the money rolled in, they just couldn't turn the machine off.

And so it begins, where the top of Cole’s short-vol pyramid has gotten wiped out--the $60-$100bn in explicitly short-vol funds that were betting on pension fund overwriting, “risk premiums”, or just whacking bids in the VIX. While these funds may not have blown up in style like XIV, they have been mortally wounded by the combination of a landmine in their performance record and the demonstrable gap in liquidity for their strategies. The universal risk management strategies like VaR de-risking like those discussed by Polemic in his weekend posts will play a big role too.

Nevertheless, for short-vol the sales pitch is dead--these strategies won’t go away overnight but they will die a slow death. In the short-term, vol will subside--but the next chapter hasn’t been written yet. What does the future hold for the more subtle short vol strategies--like “volatility control” and risk parity?

That might depend on faith in the system, the continued negative correlation of equities and fixed income products, and the ability of leveraged corporations to continue servicing their debt in the event of a shock to the system or a material slowdown in global growth.  And don’t forget this….liquidity is now such that this short-gamma trainwreck may not be so easily contained within equity markets when we inevitably encounter a genuine exogenous shock to the system.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista