Monday, February 12, 2018

Vol Awakens

Monday, February 12, 2018 – Volatility awoke from its long slumber in disruptive fashion this past week, rousing investors from their complacency and sinking stocks to their worst weekly decline in two years. Nine years into the current bull market, investors have grown accustomed to a unique set of conditions: unprecedented global central bank stimulus, rock-bottom borrowing costs, modest economic growth and subdued inflation. This supportive backdrop helped usher in an era of record low volatility and rising equity valuations. As signs began to emerge that these long uninterrupted conditions may be shifting, investors were caught wrong-footed and unexpectedly forced to adjust to a new market environment.

The protracted lull in volatility was abruptly ended last Friday when a sharp rise in hourly earnings, revealed in the Labor Department's latest monthly job report, conjured up fears of higher inflation and faster than expected Fed rate increases. Inflation and rising borrowing cost worries carried over to this week and were exacerbated by further signs of accelerating global economic growth, tightening monetary policy and a widening federal deficit. Amid this turbulence, the DJIA, S&P 500, and NASDAQ plummeted 5.2%, 5.2%, and 5.1% respectively this week.

Algorithmic trading strategies and exotic investment products also appeared to have compounded this week's selling pressure. Many market observers noted that drawdown may have been inflamed by systematic models that need to balance their risk or rely on technical signals. One cited example was the spike in selling after the S&P 500 and other major indexes broke below key technical indicators such as their 50 and 100-day moving averages, which likely triggered automatic selling activity.

Another notable development and the biggest headline in ETF news was the explosion in volatility and its impact on volatility-linked products. In a reversal from last year's historically low volatility levels, the VIX registered its largest one day increase on Monday and continued its wild price swings throughout the week. This had ruinous implications for ETPs tied to one of 2017's most popular and profitable trades: shorting volatility. A sustained period of market calm had lured investors into arcane investment products that benefit from declines in volatility: inverse VIX ETPs.

The ways in which inverse VIX ETPs are designed and function made them untenable in periods of such heightened volatility. Through selling short futures on the VIX, they had profited from the recent stretch in market calm in two ways: 1) The decline in volatility to record lows and the profits that arose from pursuing a short strategy tied to this decline. 2) Reaping gains from contango in the VIX market, whereby longer-dated futures had the tendency to be higher priced than the VIX spot price. By constantly rolling over positions to sell more distant futures, these strategies had a secondary source of profit.

However, as this week's events demonstrated, these products are ill-equipped to weather periods of sharp spikes in volatility. After the VIX surged a record 116% on Monday, the NAV of these products plunged to zero and triggered trading halts and certain liquidation clauses. For example, Credit Suisse, the sponsor of the $2 billion VelocityShares Daily Inverse VIX Short-Term ETN (XIV), stated in the fund's prospectus that it reserved the right to "accelerate" the product if the underlying futures contracts increase by more than 80% in a day and its intraday indicative value was equal to or less than 20% of the closing day's indicative value. Without the recourse of margin call, Credit Suisse had to quickly cover all of its positions and liquidate the product before being on the hook itself. The record rise in the VIX left Credit Suisse scrambling to hedge itself in afterhours trading to keep the ETN's value above zero. This forced buying of VIX futures following such market turmoil added further upward pressure on the VIX and led to now what is an unrecoverable loss for the fund. XIV lost over 90% of its value that day, while another similar product, the ProShares Short VIX Short-Term Futures ETF (SVXY), lost over 75% and was halted for trading. XIV received a 17.05% bump in its ETFG risk rating this week, while SVXY's risk rating rose 12.2%

The chaos surrounding these products serves as yet another reminder to carefully read a fund's prospectus before making an investment decision and avoid esoteric products whose risks you do not fully understand.

Did this week's market action presage a paradigm shift? Or will the backdrop of robust corporate earnings and synchronized global economic growth help tame market volatility and resume the upward march of equities? Investors will have to reconcile these conflicting signals as we enter the week ahead.

It could be another eventful week in the markets, please consult our Quant Model for daily updates to Ratings and Rankings.

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