Is my fear gauge on the fritz?

Transcription

1 DRIEHAUS CAPITAL MANAGEMENT // MAY Is my fear gauge on the fritz? Recently, much has been written about the collapse of volatility and the level of complacency in the marketplace, most notably highlighted by the VIX index breaking into single digit territory. We ve fielded a growing number of inquiries as to the drivers and sustainability of the low level of volatility, as investors question the implications of the seemingly extreme low vol readings. With that in mind, we thought it would be helpful to deconstruct a few of the widespread misconceptions related to the current low volatility environment, as well as consider how to best traverse the landscape. First off, let us address the simple reality before delving into the deeper stuff: the VIX is currently justifiably low for a multitude of reasons: Exceptionally/historically low realized volatility year to date Buy the dip mentality permeating throughout the markets, essentially cutting off the tail portion of distributions Elimination/Removal of pending imminent events to derail the market s run Increased use of volatility selling strategies, primarily focused on near dated options, seeking to enhance yield All of which point to the fact that the marginal player today is a seller of volatility, while the incremental buyer of protection appears to be on strike, thereby creating a supply and demand

2 DRIEHAUS CAPITAL MANAGEMENT // MAY And yet, all this has been known for quite some time, and still the market is now observing levels of volatility that are exceptional to say the least. So what gives? Decomposing the misconceptions surrounding the VIX, its consequences and use as a tool, are critical factors in explaining the current state and why it is garnering so much attention. Below we address some of the most common misperceptions regarding the VIX Index and its implications, as well as observations and analysis one can make to paint a clearer picture. While not an exhaustive list, the points highlighted are meant to touch upon today s hot button issues as we look to shed some light on the topic. Misconception #1: The VIX is a tradable instrument, so I should spend my time anchoring to its price While the headline spot VIX gets the lion s share of the attention, it is in fact, not a tradable instrument. The VIX is a mathematical calculation of a strip of options prices on the S&P 500 Index, essentially a statistic. ETFs, ETNs, and derivatives on the VIX are priced off of corresponding VIX futures. How to address? Therefore, to truly understand what is embedded in investor expectations and fear, one must focus on the VIX futures curve. A better barometer for investor angst in this regard is the three month index (VXV) or the third month VIX future (UX3). This tenor smooths out the near term noise associated with the VIX and provides a clearer look at a broader time horizon, more closely aligned with investor timeframe. During periods of heightened market fear, the relationship between spot VIX and the third term will invert, highlighting the stress working through the financial system. Under normal circumstances, one would expect the VIX to be below VXV, as it is today. Exhibit 1: VIX vs VXV Source: Bloomberg driehaus.com

3 DRIEHAUS CAPITAL MANAGEMENT // MAY Misconception #2: Low VIX readings mean investors are in fact complacent Perhaps. While this in fact can be true, it is not a necessity by definition. One must peel back additional layers in order to make an informed assessment of volatility. Does realized volatility support a low VIX? Will upcoming catalysts change the volatility regime? Are investor positioning and fund flows supportive of muted market volatility? These are just a few of the checklist items worth rifling through to assess the relative level of the VIX, not merely the absolute number. How to address? Beyond cross checking the data, it is vital to keep in mind two things: 1. The VIX and expectations for volatility can change abruptly so while a low VIX may appear to point to complacency today, it does not make a statement on medium term expectations or the pace at which views can change. 2. As the growing impact of short dated SPX options continues, periods of low realized volatility will have an increased impact on VIX readings. Roughly 30% of SPX options outstanding now expire within two weeks, and as systematic volatility selling continues as a source of yield, volatility levels may appear overly sanguine. Further, the use of short dated options allow investors to quickly rent protection and cover risk via weekly options as market conditions turn. Exhibit 2: Almost 30% of SPX option volume has two weeks or less to maturity and is within 2% of spot Source: Deutsche Bank,

4 DRIEHAUS CAPITAL MANAGEMENT // MAY Near dated volatility expectations are heavily skewed by most recent realized volatility. During periods of calm markets as experienced year to date, implied volatility gets dragged lower to compensate for the small daily movements. So far, 2017 has only had four days of movement greater than 1% in the SPX, and no single day with a 2% move. Compare this with the long term average of 61 and 14, and the level of implied volatility appears quite different. Exhibit 3: Volatility levels over time # of Trading Days Year >1% >2% Long Term Average* *Long Term Average is Source: S&P, Bloomberg, RBC Capital Markets Misconception #3: The VIX acts as blanket barometer for market fear and volatility expectations Again, there is some truth to the statement, but only partially. While the VIX captures equity implied volatility of the benchmark product for U.S. equities via S&P 500 options, it is by no means all encompassing. Often, different parts of the market will have mixed signals with respect to volatility expectations and portrayal of angst across different investor bases. While the VIX is a key cog in the wheel, additional asset class volatility benchmarks must be used to properly asses volatility, let alone whether it is appropriately priced or not. So what is one to do? As financial markets become increasingly intertwined, and the impact of monetary and fiscal policy takes center stage, the importance of cross asset volatility has risen. The information in one corner of the market often provides insight to other aspects, both confirmatory and contradictory. This is no less true for volatility, where spillover effects can lead to outsized impacts given the nature of convexity in volatility. As such, having multiple relevant data points in hand produce a more robust picture. Among the varying asset classes FX, Commodity, Rates, Credit and Equities each play a leading roles at times. The growing importance of cross asset volatility and correlations suggest that tracking the VIX index alone as the fear gauge does not suffice, and a more holistic approach to volatility is needed. This is particularly true when the data diverges. driehaus.com

5 DRIEHAUS CAPITAL MANAGEMENT // MAY Exhibit 4: History of Global Cross-Asset implied volatilities Source: BofA Merrill Lynch Global Research (data from May 1, 2007 to May 8, 2017). 3M ATM implied vols on Equities (S&P 500, ESTX50, FTSE 100, Nikkei 225, HSI), Interest Rates (Europe and US), FX (EUR/USD, USD/JPY, GBP/USD) and Commodities (Crude Oil, Gold and Copper). Source: BofA Merrill Lynch Global Research (data as of May 8, 2017). 3M ATM implied vols on Equities (S&P 500, ESTX50, FTSE 100, Nikkei 225, HSI), Interest Rates (Europe and US), FX (EUR/USD, USD/JPY, GBP/USD) and Commodities (Crude Oil, Gold and Copper). Assessing the volatility landscape has become a more complex endeavor these days with the emergence of volatility as an asset class and the use of volatility strategies to both mitigate risk and generate returns. Therefore, it should come as no surprise that the accompanying analysis should go beyond referencing the VIX we ll leave that to CNBC. We often get asked during low volatility periods if vol is cheap. Our answer has evolved over time, but to put it simply we have made a habit of explaining that low does not equal cheap. It may sound elementary, but the distinction is paramount. The latter ends the discussion, the former merely begins the

6 DRIEHAUS CAPITAL MANAGEMENT // MAY Disclosures This update is not intended to provide investment advice. Nothing herein should be construed as a solicitation, recommendation, or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. You should assess your own investment needs based on your individual financial circumstances and investment objectives. This material is not intended to be relied upon as a forecast or research. The opinions expressed are those of Driehaus Capital Management LLC ( Driehaus ) as of May 23, 2017 and are subject to change at any time due to changes in market or economic conditions. The commentary has not been updated since May 23, 2017 and may not reflect recent market activity. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable and are not necessarily all inclusive. Driehaus does not guarantee the accuracy or completeness of this information. There is no guarantee that our observations will come to pass. Reliance upon information in this material is at the sole discretion of the reader. DRIEHAUS CAPITAL MANAGEMENT driehaus.com