Unease grows about bets on market stability

Financial markets have been remarkably tranquil this year, but some money managers and analysts fear that is leading to a build-up of bets on continued stability that could unravel spectacularly when turbulence reappears. 

Various measures of actual and expected stock market volatility have fallen to post-crisis lows this year, but some investment managers and strategists warn this is building risks of a bigger decline — comparing it with a forest that has gone too long without a bushfire, which produces an increasing amount of dry kindling for an eventually larger conflagration. 

“We are at an unprecedented time of low volatility, which typically presages epic downturns,” said Christopher Cole, the head of Artemis, a volatility-focused hedge fund. “I would be shocked if this market regime of low volatility will endure.”

The concern that any snapback could prove ferocious is partly driven by the rising popularity of betting on turbulence staying subdued — or “shorting vol” in Wall Street slang. It is a trade that has proven very profitable in recent years. 

One exchange-traded note that gains when the Vix index of expected short-term US equity volatility falls — the VelocityShares Daily Inverse VIX Short-Term ETN — has handed investors returns of more than 500 per cent since 2011, as post-crisis bouts of turmoil have quickly dissipated, with many investors seeing any sell-off as a chance to load up on more stocks. Increasingly, analysts say even some institutional investors are now systematically betting against volatility to invigorate their returns.

“There are so many people in this short volatility trade that it’s breaking the plumbing on markets and they're not reflecting the risks," says Adam Sender, head of Sender Company and Partners, a hedge fund. “What is going on right now is unhealthy. Investors are being trained to short volatility at every 1 per cent sell-off.”

The worry is that if volatility does erupt and stays elevated, investors burnt by bets on tranquility will have to scramble to offset their positions by shorting equities or buying volatility protection, in turn worsening the turmoil. 

“My fear is that we’ll have a sell-off: people selling vol will have to back down and cover themselves and we’ll have a 1987-style event,” Mr Sender says, referring to the Black Monday crash that was exacerbated by a trading technique called “portfolio insurance”.

Tad Rivelle, the fixed income chief investment officer at TCW, blames central banks for easing monetary policy too readily whenever turbulence threatened to return after the financial crisis, and argues that as a result the next market rout will be a “doozy”. 

Some analysts argue these fears are overdone. Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors, says most investors selling volatility are doing so carefully. Some fingers will be burnt if the flames of volatility are fanned, but the chances of a conflagration are minimal. 

“The only way to get a really extended period of volatility is when something real happens, like the financial crisis,” he said. 

Bill Speth, head of research at the Chicago Board Options Exchange, which owns the Vix index, also sees parallels to the feedback loops that caused carnage in 1987. But he said he took “some comfort” in the fact that derivatives being used to short volatility were traded transparently on exchanges and cleared by clearing houses.