Who's Afraid of Low Volatility?

Issue 08-07-17   |   Reviewer:   Delvin D. Hawley, Ph.D.
Disciplines:


Abstract

Investors who bet on calm have done very well lately. One of the most popular vehicles for betting on low volatility in the market, an exchange-traded note from VelocityShares, delivered an 180 percent return over the past year. The VIX finished below 10 on only 26 trading days from 1990 through Aug. 2, 2017, and 17 of those days occurred since the start of May.

The persistence of extreme calm over a long time span may have pushed investors toward strategies that could blow up if volatility returns. According to the late economist Hyman Minsky, stability creates its own instability. Professional investors who thrive on volatility find it harder to make a living when markets are calm, so they invest with borrowed money to amplify their meager returns. That makes them vulnerable to a price decline, and stock markets in the U.S. and other countries are more vulnerable to a big selloff than one would think from looking at the VIX alone. S&P 500 price-to-earnings ratio has been climbing consistently over the last five years, and its current high of 21.3 indicates to many that stocks are overpriced.

Since the VIX tends to rise when stocks fall, investors’ first thought was to buy VIX products as a hedge against losses on high stock prices. That turned out to be a bad idea because stocks didn’t fall. The new game is to go the opposite direction and bet on volatility staying low or even falling using complex securities like VelocityShares inverse VIX note. The effects of these complex new ways to bet on market behavior are unpredictable, but it’s easy to imagine how things could go bad. If the VIX rises because the stock market is dropping dramatically, investors who bet on a low or falling VIX must quickly find a way to offset their losses. One way to do that is to bet that the stock market will continue to fall. Selling could breed more selling with few market players willing to take the other side, and the effects could spill over into the stock market itself. Such a chain reaction could be set off by, among others, a flirtation with a U.S. government default in September if Congress can’t agree to raise the debt ceiling or a worsening of the North Korea situation.

The main reason to worry about the stock market isn’t the VIX, of course. It’s that stock valuations are historically high and dangers lurk. But the complacency reflected in the VIX tends to make those basic problems scarier.





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