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Stocks’ drop brings scrutiny of complex low-volatility bets
NEW YORK, Feb 12, 2018 (BSS/AFP) – Wall Street’s plunge this week has
brought scrutiny to complex niche products to trade on volatility that market
experts believe were poorly structured and exacerbated swings in stocks.
Only days before markets began to go haywire, Barclays chief executive Jes
Staley warned about the risky investments at the World Economic Forum in
Davos.
Many investors were using the exchange-traded products to place bets that
volatility would stay low or go down, a “very smart” wager during a period of
persistently low volatility, Staley said.
“But if this thing turns, hold on to your hat,” he added.
That change took place on Monday as the Dow Jones Industrial Average was
in the midst of a more than 1,000 point drop that included a violent 800-
point dive in the blue-chip index over 10 minutes.
During that period, the CBOE Volatility Index, known as the “VIX” index,
also shot higher.
That shift spelled instant losses for “short-vol” trading vehicles,
including exchange traded products by Japanese bank Nomura and Credit Suisse
that had predicted volatility would go down, known as a “short” investment.
Because the VIX is known unofficially as Wall Street’s “fear” index over
possible bad future outcomes, a sudden surge likely contributed to the brutal
losses in the equity markets.
– Popular bet –
Short bets on volatility had become a popular stance, outnumbering trades
that anticipated a rise in volatility and in one case earning a return of
almost 200 percent in 2017, according to a note from Goldman Sachs.
“Hedge funds, prop traders, retail investors… everybody was on the same
exposure,” said Brett Manning, senior market analyst at Briefing.com. “It
worked really well for a long time.”
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But the investment suddenly went south when markets turned sharply on
February 2, when a surprisingly strong US jobs report sparked worries about
inflation.
“Everybody was on the same side of the trade,” said Manning. “Hedge funds
started to move out and people started to panic to cover these investments.”
Conditions worsened this week, leading both Credit Suisse and Nomura to
liquidate their funds amid heavy losses.
In the aftermath of the turbulence, Fidelity Investments halted trading on
exchange traded funds that bet on low volatility.
While it’s impossible to know the exact losses, the market was estimated
at between $3 billion and $4 billion, a small part of the overall market for
exchange traded products, a growing type of investment that is traded on
exchanges and based on assets, such as stocks, commodities or indices.
The investments were widely known in the financial world as failure-prone
because of the tendency of markets to eventually become volatile.
Credit Suisse even warned in its prospectus that the “long-term expected
value” of the investment is “zero.”
“The main purpose was to be an insurance but people started buying and
selling it in sort of a casino fashion,” said FTN Financial chief economist
Chris Low.
– More scrutiny –
Regulators are now looking more closely at the vehicles. Swiss regulators
are following up with Credit Suisse, and New York Federal Reserve President
William Dudley pledged more scrutiny of the products.
Asset manager BlackRock called for a “regulatory classification system
that would label levered and inverse exchange traded products differently
than plain-vanilla (ones) in order to clarify for both regulators and
investors the risks associated with those products.”
One consequence of this week’s shakeout is that the products in question
have been “significantly defanged,” making a repeat peformance of the
February 5 chaos unlikely anytime soon, said a note from Bank of America
Merrill Lynch.
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