The Independent Market Observer

The Role VIX ETPs Played in Recent Market Volatility

Posted by Brian McCormick, CIMA

This entry was posted on Feb 23, 2018 1:11:00 PM

and tagged Commentary

Leave a comment

VIX ETPsToday's post is from Brian McCormick, manager of Commonwealth's Investment Management and Research team.

Monday, February 5, 2018, was a brutal day on Wall Street. The Dow Jones Industrial Average saw its largest point drop in history, closing down 1,175 points. The unprecedented decline also rocked other market measures, most notably the CBOE Volatility Index, commonly known as the VIX. The VIX, which measures how calm or nervous investors are, experienced its largest spike in history, rising 116 percent on February 5. Its previous record was just 64 percent.

An indirect effect

This spike in volatility made the pullback worse than it might otherwise have been, but by an indirect route. First, we need to understand that on Wall Street, if you can measure it, you can invest in it. In recent years, a number of products have been created to provide investors with exposure to volatility by investing in VIX futures contracts. In fact, at last count, there were 24 exchange-traded products (ETPs) that invest in VIX futures contracts in some fashion—some are long volatility, some are short, and some even provide leveraged exposure to VIX futures. Some of these products have (or had) billions of dollars in assets.

These products have legitimate uses. Many investors, for example, use long VIX ETPs as a hedge in case markets drop, since they are supposed to go up. On the flip side, though, some investors have been seeking to take advantage of the steady rise in the markets and low volatility throughout most of the past two years by investing in short volatility products.

Assets in inverse volatility products appreciated dramatically in 2017—with some up as much as 180 percent for the year and others providing a five-year annualized return of more than 50 percent! As investors chased this performance, assets in short volatility products ballooned to $4 billion. And that was the problem.

On February 5, when the VIX spiked late in the afternoon, the sponsors of these short volatility products scrambled to cover their exposure, while other related products were also forced to respond. In order to rebalance their portfolios to track their underlying indices, these sponsors had to buy, by some estimates, approximately 230,000 VIX futures contracts at the end of the day on February 5. This surge in demand, coupled with limited supply, pushed up the price of VIX futures drastically, resulting in the 116-percent spike in the VIX. This, in turn, led to an average price decline of 96.1 percent for the two major short volatility products. But, more important, it also rattled financial markets.

Since the VIX is a major indicator of market fear, that spike appears to have led other investors and traders to react by selling, which worsened the decline. What was a technical issue, confined to a couple of products trading in derivatives, turned into a significant contributor to the market decline. This is a good example of how one aspect of the markets can affect others.

Back to normal?

Since then, of course, as the volatility trades have normalized, so has the VIX—and so have markets in general. Fortunately, this type of volatility effect should not be a problem in the future. As it stands now, one of the two products responsible is being liquidated, while the other is now less than 1 percent of the market, so it will no longer be a risk factor. Is another volatility spike possible? Sure, but we should not see these VIX ETPs negatively affect the market as they did early this month.


Subscribe via Email

Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®