When a man goes bankrupt it happens in two ways: first gradually, then suddenly.
Those who look to financial markets for meaningful information about the future must accept the risk that the market may be wrong. The problem for those who place their faith in its predictive powers is that — like the bankrupt described by Ernest Hemingway — when investors discover they are wrong they too realise it in two ways; first gradually, then in a sudden panic.
One of the reasons markets, in moments of extreme stress, are prone to reset their expectations for the future violently, rather than in a smooth and orderly manner, is because the signals different asset prices send are self-reinforcing. When one type of market appears to offer a rosy prognosis this can be taken as a cause for optimism in an entirely different market.
When that market then also begins to rise it may, in turn, provide justification for the other market to be bid up further by investors, a process George Soros called “reflexivity”. If one of these signals turns out to be wrong then investors in both markets have to make swift and brutal adjustments.
Since the 2008 financial crisis one of the most closely watched forward-looking measures for market stress and riskiness has been the VIX index, which has been given by some the title of “Wall Street’s fear gauge”. The VIX is the name given to the Chicago Board Options Exchange’s volatility index, which takes as an input the implied volatility of options being priced on the S&P 500 to provide a market-based signal for the expected volatility of large US stocks over the coming 30 days.
The VIX tends to jump when the US stock market is falling and to subside when shares are rising. As such the VIX has assumed an increasingly important role as an indicator of how risky the world appears at any given moment, providing guidance for human investors when it spikes, as well as computer-driven algorithms which are said to use it as a statistical input for their trading models.
The risk for any human or computer using the VIX as a gauge of how risky or safe the market may be is that there are reasons to believe it has become an increasingly scrambled signal over the past five years. Investors are using the movement of the VIX to guide them when, in fact, it may be being driven by dynamics that are completely unrelated to the outside world.
Russell Clark of Horseman Capital has observed how since the CBOE launched standalone tradable VIX futures contracts in 2004, the open interest of these contracts, which roughly equates with trading volumes, has seen a huge jump since 2010. Until 2009 there was no way non-professional investors could trade VIX futures, Mr Clark notes, meaning volumes were relatively low and the VIX tended to move in line with the net position of large institutional money managers.
That changed in 2009 with the launch of the first VIX-linked exchange traded fund (ETF) products, which for the first time made investing in the VIX accessible for retail investors seeking to hedge themselves by using the index. Coinciding with the launch of these products, open interest in VIX futures increased from less than 100,000 contracts in 2009 to more than 400,000 by 2014.
These not only allow retail investors to speculate on the VIX going up, indicating a rise in expected volatility in US stocks, but also on the VIX falling, with some of them being leveraged to provide their users with even greater bang for their buck. These VIX funds are also heavily traded by high frequency firms, with the value of shares in the three largest on some days in 2015 approaching nearly a tenth of the value of all shares traded on the New York Stock Exchange.
As a function of their design these products must constantly roll over their positions in VIX futures before they expire, yet the futures they trade in tend to only be liquid enough to buy in and out of easily for the first two months of their lives. When investors purchase shares in these exchange traded products, it causes them to become forced buyers or sellers of the VIX futures depending on whether the particular product is designed to be long or short the VIX.
As such, according to Mr Clark, when the three largest VIX exchange traded products are rebalancing they tend to push up the price of certain contracts and push down the value of others. “The structural tendency for the VIX ETFs to sell short-dated VIX futures and the huge volume being traded in these ETFs mean that when they are net long they tend to depress the actual VIX Index that it is meant to mimic,” he argues. In short, it is possible that the tail has begun to wag the dog.
This should cause concern for anyone currently using the VIX index as an independent variable to inform their decisions. Stock market investors who have been finding solace in apparently subdued volatility may one day be in for a violent awakening.
