Map to the underworld: US$2 trillion of volatility trades

LONDON: For a fledgling asset class whose idiosyncrasies are understood by few, there sure is a lot of money swirling around in volatility trades.

Investment strategies and products married to market swings were thrust front and centre by the worst market meltdown in seven years, in which the Cboe Volatility Index surged to its highest level since 2015. VIX-related securities were halted, volatility-targeting quants blamed, and options trading in benchmarks for turbulence ballooned.

Too big to ignore, it is an asset class in its own right, with the might to push around the broader market. Getting a grip on it has confounded strategists and managers alike. Even its designers are amazed by its heft.

“It doesn’t surprise me that it’s become so big. What surprises me is that it’s in some ways sapped liquidity from other parts of the market,” said Michael Schmanske, the founder of Glenshaw Capital Management who previously worked at Barclays Capital and helped oversee the launch of some of the first VIX exchange-traded products (ETPs).

“These guys have taken volatility to the next level and believe it needs to be part of a managed portfolio.”

There are two categories of securities linked to price turbulence, roughly speaking: ones tied to the VIX directly, and others that take their cue from the volatility of individual stocks. Altogether, estimates for the space are anywhere from US$1.5 trillion to US$2 trillion. Beyond that is the options market, which itself is an implicit bet on swings in shares.

Volatility-targeting funds

Funds that fall under this category use realised volatility as data inputs and were called out as potential culprits for exacerbating Monday’s trading.

Volatility is key to the investment decision of these programmatic funds often employed by pensions and insurers – a specific level is set, and leverage will be adjusted to maintain that objective depending on how much each asset class swings.

Theoretically, if stocks begin to trade wildly, they may scale back their footprint. Or, in the case of Monday, they may have been selling into the downturn. Estimates from both Barclays Plc and Societe Generale SA pin the space between US$400bil and $500bil.

Risk-parity funds

Risk parity often gets lumped in with vol-targeting funds because asset riskiness is a central input. However, they operate quite differently.

Risk parity attempts to hold an equal amount of risk across asset classes and uses longer-term volatility inputs – it won’t trade based on a few days of volatility spikes.

Risk parity has been called out before as the equivalent to portfolio insurance in 1987, a hedging technique that systematically sold stock-index futures as the equity market declined, creating a vicious feedback loop that caused the market to crash.

Based on back-of-the-envelope math, risk-parity funds have about 1/100th of the capacity to move markets as portfolio insurance did in 1987, according to AQR Capital Management estimates.

The Greenwich, Connecticut-based quantitative money manager estimates the size of risk-parity funds to be between US$120bil and US$250bil, with AQR and Bridgewater Associates LP’s All Weather Fund being the largest players. Others estimate the space is larger – SocGen sees it at twice the size.

CTAs

The market’s boogeymen, commodity-trading advisers (CTAs), are related to volatility because these trend-following managers often use market swings as inputs to select the sizes of their positions. Leverage among the funds may be smaller than before the financial crisis, but they’ve been able to accrue more assets as momentum across markets marched forward to boost returns.

Asset under management (AUM) for them is about US$250bil, according to SocGen data through 2017. Prior to Monday’s selloff, they also held a near-record footprint in both equities and commodities.

VIX ETPs and VIX-related strategies

Products directly linked to the VIX may manage as much as US$8bil, according to SocGen estimates.

ETPs, like the VelocityShares Daily Inverse VIX ETN, known by its ticker XIV, have been directly blamed for causing the VIX to spike Monday as they were forced to de-risk with surging volatility. Credit Suisse, with a market cap of about US$46bil, is the note’s backer and has said it will buy back the ETN.

Assets in the ETPs have significantly shrunk in size since Monday’s maelstrom: short-volatility ETPs manage US$700mil, down from a record US$3.7bil in January. Including long-volatility funds, assets total more than US$3bil.

As for strategies tied to the VIX – which play on the gauge with a combination of futures and options – there’s between US$2bil and US$4bil behind the trades, according to SocGen.

Derivatives market

This one is the behemoth, and can take many different forms. For example, variance swaps are derivative contracts that make a bet on the magnitude of movement on the underlying asset. But effectively, any option is a bet on the volatility of the underlying.

Over-the-counter options trading in US equities reached about US$2.7 trillion in notional amounts outstanding in the first half of last year, according to data from the Bank for International Settlements.

For listed S&P 500 Index contracts, the 20-day average notional value traded has been about US$4.2 trillion. But traders typically talk about vega, a measure of an option’s sensitivity to changes in the volatility of the underlying asset. That sits at roughly US$8bil vega.