Toby Nangle: Market volatility: Tail wags dog?

Columbia Threadneedle Investments and fund manager of the Threadneedle Dynamic Real Return Fund

Toby Nangle
The strong market performance of 2017 reflected, to a meaningful degree, investors pricing assets for a much better economic and earnings environment. The sharp drawdowns of the last week do not, to our minds, reflect a sharp deterioration in this outlook. Rather unhelpfully for the layperson, understanding the nature of the equity market weakness over the last week relies instead on digging into some arcane aspects of financial market plumbing.

The VIX index is the more prosaic name given to what is sometimes called Wall Street’s ‘fear index’. Lifting the bonnet, the VIX represents the 30-day implied volatility that falls out of pricing a range of exchange-traded options on the S&P500 index. So if there is more appetite to buy options than there is to sell options, implied volatility will rise – all else being equal.

Typically, there is plenty of appetite to sell options on the part of investment banks, who have teams dedicated to managing the risk associated with short options positions. These risks include managing the overall exposure to moves in the markets (through what is termed ‘delta hedging’) but also managing further ‘greeks’ – gamma and vega being the most prominent.

Over the last few years, investment banks have seen the pool of capital attached to their market-making activity decrease. One might think that this would see the price of implied volatility (or ‘vega’) rise. But concurrent with this development we have seen the rapid growth in exchange-traded notes (ETNs) that are structured to be short vega: they are permanent sellers of implied volatility, and as such serve to dampen its level. The growth of these funds has been important, but is only one of a series of developments in the architecture of the financial system that have collectively served to dampen implied volatility.

We understand that a series of large options trades earlier this year led hedgers to be shorter both gamma and vega than they had appetite (or rather risk capital) to sustain. With implied volatility near decadal lows, there was little appetite among natural short-sellers of volatility to increase their positions (and so accommodate this demand to hedge). The result was a rise in implied volatility to the extent that short-vega ETNs like the XIV Fund saw calamitous losses and wound up earlier this week, in turn helping the VIX to rise further as a natural seller of implied volatility exited the market.

How do changes in the implied volatility of options markets impact asset prices?

There are a number of ways. Most straightforwardly, equity prices always embed in their risk premia the implied level of volatility. And so there will tend to be good short-term linkages between the VIX and equity prices. But there are also some systematic linkages, and these have grown in recent years. The growth in the assets under management of risk-parity strategies and systematic volatility-targeting strategies (that take implied volatility as an input to their asset allocation) may strengthen the immediate linkage between VIX shocks and asset price movements: as VIX rises, so such strategies must rebalance. This has the effect of translating a rise in implied volatility into a rise in realised volatility: the tail wags the dog. Over the medium term, higher realised volatility is an input to all financial market risk management frameworks, meaning that lower levels of gross exposure to equity assets can be assumed to match a given anticipated risk appetite.

What are the risks from here?

That we understand this current move to be exacerbated by forced sellers tells us nothing about its magnitude or its duration: things that have cheapened may cheapen much further before the market clears. Asset prices have risen meaningfully over a number of years, and long-term investors are sitting on large gains. Furthermore, some of the factors supporting markets over recent years have been beginning to turn: the prospect of more quickly-rising interest rates in a number of developed countries and the glacial unwind of QE in the US, as well as glimmers of wage growth have emerged almost everywhere.

Corporate debt load is high and so unanticipated knocks to corporate earnings will have larger consequences for financial markets. Valuations, while cheaper than they were a week ago, are not cheap. All this tempers our exuberance to increase equity allocations far in excess of where they stood when equity markets were last at current levels.

What have we done in portfolios?

There is nothing in the equity market move to date to give us concern that the strong global economic growth profile or the strong earnings per share growth profile that we forecast will be put in jeopardy. As such these market moves look like a valuation – rather than a fundamental – event. Valuations in both equity and bond markets did not start at a particularly cheap level, but we saw large pockets of compelling value. Understanding that the equity market drawdowns may deepen for reasons of financial plumbing outlined above makes us cautious not to step in the way of large systematic funds that may still be forced to liquidate. But we are taking the opportunity to increase exposures to favoured markets, capturing the value lost by market participants that have become forced sellers. News Wire & Equity Research: +31 084-0032-842

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