Is the Cboe Volatility Index® being manipulated? It’s a provocative question that was on the lips of some investors and market watchers this past spring after they noticed unusual activity in the VIX® in April. We wrote about the episode, observing that what looks like manipulation isn’t necessarily so. The VIX could experience intense fluctuation for other reasons. Nevertheless, the VIX’s historical settlement process left it open to manipulation, and the controversy stung.
But something good may yet come of it: On June 20 the Wall Street Journal reported that Cboe is taking steps to revamp the monthly auction that determines the settlement price for VIX options and futures. Some might argue that Cboe’s hand was forced, since its equity shares were down 16% over the first half of 2018, with many analysts indicating that concerns about the VIX franchise were a leading cause.
Spring has stung: a VIX timeline
Sources: Cboe, Wall Street Journal
What is the VIX?
The VIX, commonly referred to as the market “fear gauge,” attempts to measure the 30-day expected volatility of the S&P 500® Index. It does this by looking at the implied volatility of short-dated, out-of-the-money S&P 500 Index options. Historically the VIX rises when the S&P 500 falls (investor fear increases) and falls when it rises (investor fear decreases). Futures and options on the VIX are settled monthly using an auction process for S&P 500 options to determine the final index settlement price. Many investors look to the VIX index as a forward indicator of market uncertainty.
What’s changing with the VIX?
In general, all the changes fall under the header of increased liquidity during the auction. First, Cboe has transitioned all S&P 500 Index options to a more electronic-friendly platform. As amazing as it may seem to some, until recently a large portion of S&P 500 option trading was constrained to traditional open outcry pits—think of Dan Aykroyd and Eddie Murphy in Trading Places, and you get the picture. The other big change is that Cboe plans to enhance quote streaming for traders, providing them with more frequent updates during the settlement auction.
The hope is that both of these changes will encourage more traders to participate in the market during auctions. The potential for more liquidity during the auction will make it difficult for nefarious actors to manipulate prices if, in fact, manipulation was occurring in the past. (It should be noted that the May and June VIX settlements passed without incident.)
The bottom line
What does all this mean for investors? As noted in our previous blog post on the VIX, no one ever claimed the index was being rigged outside of a very narrow settlement window. If you didn’t hold VIX options or futures into settlement, you were likely not affected. Thus, the changes will have minimal direct impact on most investors.
The indirect impacts, though, could be profound. The steps taken by Cboe make it more likely that the VIX shakes off the “rigged” taint and that its associated futures and options survive in the long term. Given how important the VIX is as a market indicator and benchmark, we’d argue this is a positive outcome for investors.
Potential Parametric Solution
We manage over $17 billion in investment strategies that seek to capture the volatility risk premium (VRP), a well-researched return premium evidenced by the discrepancy between the implied and realized volatility of equity index options, the very options used in the construction of the VIX. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA - Managing Director - Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Centers. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to risk parity.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.