After last Monday's terminal event for the XIV - which at the time was the second largest inverse VIX ETN, before a the so-called volocaust and the subsequent record VIX eruption, resulted in a 96% NAV loss and subsequent termination "acceleration"...
... one would assume that retail investors - the target audience of volatility ETPs - had learned their lesson and after suffering a near total wipeout, would stop shorting vol and in general, no longer collect pennies in front of steamrollers. One would be wrong.
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But first, a quick reminder oh how various investor classes use VIX-linked products (including options, ETNs and ETFs).
At the top are the institutional traders, virtually all of whom have been forced after a decade of central bank yield and vol suppression to turn massively short-vol, and use the decay in theta as a source of "dividend" income. According to
Fasanara Capital, the consolidated value at risk among all explicit and synthetic institutional vol shorters is about $22 trillion. One way of gauging institutional investors’ demand for equity hedges, particularly tail risk hedges, is by looking at put and call open interest on VIX options. The use of VIX options has increased significantly since the Lehman crisis by investors seeking to hedge against equity tail risk, credit exposure or volatility exposure. As JPM confirm, several investor types such as vol targeting (equity or multi asset) funds or risk parity funds are structurally short volatility and "VIX calls provide the most direct and liquid way to hedge their short volatility exposure."
The JPMorgan chart above shows the VIX put and call open interest, and suggests that after the ratio of calls to puts increased for much of 2017 it reached a high in mid-January. Since then, a rise in put interest has brought the ratio back to its average level since 2014. One explanation is that the recent collapse in equity index volatility to record lows induced demand for protection against a volatility spike. And with such a spike materializing this week, institutional investors appear to have taken profit on some of these hedges this week.
What about retail investors? This is where things get messy.
First, the explainable behavior: retail investors tend to buy VIX ETFs as equity hedges. When it comes to plain vanilla non-inverse VIX ETFs - which have seen their value implode over the years as a result of a artificial, central bank-induced decline in volatility - retail investors continued to buy VIX ETFs until mid-January. Then, similar to the behavior of institutional investors over the past two weeks amid rising vol, retail investors have been sharply exiting Vol hedges.
And now the inexplicable: after getting absolutely crushed on their inverse vol exposure, retail investors have... doubled down, and according to Bloomberg data and JPM calculations, inflows into inverse VIX ETFs, i.e. selling volatility, have increased sharply over the past two weeks. This can be seen on the black line in the chart below, where inflows to inverse VIX ETF has soared by $2 billion since the end of January. Specifically, last week saw net inflows of around $850mn, and despite the collapse in prices of inverse VIX ETFs early this week net inflows in dollar terms increased to just over $1bn.
In other words, the turmoil in inverse VIX ETNs has thus not deterred retail investors from pouring money again into short VIX ETFs, similar to their behavior in previous spikes in volatility. If anything, retail investors are doubling - and in some cases quadrupling - down on bets that vol will drop.
Why? Very simple.
As we showed earlier, after the events of the last two weeks, Bank of America's "Critical Stress Signal" was triggered, which while pre-2013 indicated that a major market selloff was imminent, has since 2013 transformed into a "contrarian buy" signal, as it preceded - on 5 out of 5 occasions - central bank intervention, either actual or verbal and a surge in risk assets.
So why are retail investors betting that VIX will crash from its lofty 30+ levels?
Because they are confident it will be 6 out of 6.
Because they are certain that should things get worse, the Fed will once again step in and stabilize markets, which as we explained earlier, could be a fatal gamble this time around.
And as a result, the Fed is again trapped: if the selloff continues - or accelerates - next week will face a lose-lose dilemma - bail out retail (and institutional) vol sellers, and while preventing trillions in losses, lose all credibility and confirm that the "coordinated recovery and strong economy" narrative was a lie all along, while derailing what is likely the last tightening cycle; or allow normalization to take place, and watch as trillions vaporize from the Fed's artificial "wealth effect."
We wish Jay Powell the best of luck as he faces the most critical question of his career just days into his tenure as the Fed's new chair, and wish to remind him of what he said at the October 2012 FOMC meeting:
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.