2017 was one of the least volatile years on record. For the year, the average daily level of the CBOE Volatility Index® (VIX)—a popular barometer of U.S. equity market volatility—was 11.09, the lowest annual average since the index’s inception in 1990. Last year, the VIX closed below 10 on a total of 52 days, another annual record.
When complacency leads to risk-taking: Naked selling of VIX futures
Unfortunately, such extended periods of low volatility can lull investors into complacency and lead them to take risks they otherwise may have avoided. Case in point: Naked selling of VIX futures, or shorting forward 30 day implied volatility on the S&P 500® index, an idea that gained popularity in the placid days of 2017. Investors sell a VIX futures contract with the expectation that they will earn the positive carry. What could go wrong? As it turns out, several major things.
Shorting VIX futures and exchange-traded products
The investment landscape became more complicated when the concept of shorting VIX futures was packaged into exchange-traded products like exchange-traded funds (ETFs) and exchange-traded notes (ETNs) for the masses to consume. Products like VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY) were designed to move inversely to the daily performance of the VIX. By buying these exchanged-traded products, investors positioned themselves to profit from decreases in the prices of VIX futures contracts.
Investors in these exchange-traded products enjoyed winning returns of well over 150% (or more) in 2017—but there was significant risk lurking under the hood. For many of the products, a sharp rise in the VIX could trigger losses from which the fund may never recover. For example: If the average price of VIX futures rises from 10 to 20, that represents a 100% increase—which translates to a 100% loss for the investor in the short VIX ETF or ETN.
In fact, many of the ETFs and ETNs had thresholds below 100%. When the value of the product declines more than 80%, for example, hard triggers may force the fund to unwind positions—i.e., buy back the VIX futures contracts that it initially shorted—and mandate early redemptions.
As these products grew in assets under management (AUM), forced unwinding became a serious point of concern. Having to buy back VIX futures contracts would, in fact, drive the VIX higher and accelerate the product’s losses. Many market participants saw the potential for destabilizing trades on the horizon; this has been written about extensively by academics and investors alike.
VIX in the news
This problematic scenario is exactly what happened on Monday when the VIX rose 20 points, its largest single-day absolute or percentage change. This change in the VIX index translated into a similar price movement in VIX futures—the March 2018 VIX futures contract price on February 5 is shown below.
The move was, in part, driven by forced buying of VIX futures by short VIX ETFs and ETNs. It is estimated that this collection of short VIX products purchased close to 100% of normal daily volume near the market close on February 5, pushing the futures price up toward 30. On a net basis, the short VIX products lost nearly 95% of their value in a single day. And the party was officially over.
The bottom lineWhile it was a painful reminder of how markets work, in our view, the removal of these systematic short volatility players is ultimately a benefit to the more prudent volatility sellers who remain.
Potential Parametric solution
Our Volatility Risk Premium (VRP) Strategies aim to provide a persistent source of return without the use of leverage or market forecasts. They do so by harvesting the VRP, a well-researched phenomenon based on the discrepancy between the implied and realized volatility of equity index options. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA, Chief Investment Officer, Equities and Derivatives
Tom leads Parametric’s Research, Strategy, Portfolio Management, and Trading teams, coordinating resources, aligning priorities, and establishing processes for achieving clients' investment objectives. Tom has coauthored articles on topics ranging from liability-driven investing to the volatility risk premium. He is a voting member of all the firm's investment committees. Prior to joining Parametric in 1994 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Tom spent two years working for the Board of Governors of the Federal Reserve in Washington, DC. He earned a BS in economics and an MBA in finance from the University of Minnesota. A CFA charterholder, Tom is a member of the CFA Society of Minnesota.
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.