What better post-mortem on the events from last week when the long-awaited volocaust finally hit, than one from Eric Peters, CIO of One River Asset Management, who just one month ago we wrote is "Betting All On A Volatility Eruption" as "A Historic Reversal Is Coming." He was right.
As a reminder, back in October, we discussed a report that several hedge funds have sprung up with just one strategy in mind: preparing for the arrival of the "fat tail", i.e., betting on a sharp spike in depressed, comatose volatility. One among them, was One River Asset Management, a manager of $700 million led by Eric Peters in Greenwich.
Just over three months later, Peters' thesis has borne out, following the biggest VIX eruption in history.
But was that it, and will vol revert back to more "conventional" level, or was last week's move just the beginning of something even bigger?
In his latest weekend letter to investors, Eric Peters explains what the two paths ahead are, and why one of them could result in Lehman-like devastation for markets and is "bombs away for risk prices."
Weekend Notes from One River's Eric Peters.
In Real Time
"We think this is very clearly the first leg of a paradigm shift to a higher volatility environment,” we wrote early Tuesday, our investment team reflecting on Monday’s remarkable events.
“The VIX ETF/ETN complex imploded yesterday/today. These products were the most exposed and thus the first to go because of their mechanics (it’s harder for VIX to double in a day from high levels than it was from low levels). Relative to the aggregate of all other forms of volatility selling, they’re not big, just really painful. They make for good headlines too. So the question now is whether the pain/spark of their blowup is enough to ignite bigger structural volatility shorts?”
“That’s a hard question to answer. There are two paths, A & B,” we continued.
- (A) “This is the equivalent of the June 2007 Bear Sterns moment. In this scenario, market participants see the VIX ETF/ETN complex implosion as an isolated event sparked by poorly constructed products. Once investors really understand how they were constructed, they gain comfort in the ‘superiority’ of the strategies that they currently use to sell volatility (uncapped variance, risk parity, vol control, put selling, etc). They feel smart. And continue selling. Until a more widespread volatility unwind inevitably unfolds - probably tied a bit more closely to the economy and QE exits by the ECB/BOJ.”
- (B) “This VIX ETF/ETN spark ignites other structural volatility shorts over the coming days/weeks, driven by a critical mass of risk managers across the financial industry not wanting to be the last to de-risk. Selling of risk assets increases volatility and this sparks more selling of risk assets in a reflexive way. In this scenario, visions of the ETF/ETN blowup makes value investors more patient in buying the dip. And with a new Fed governor, you don’t get a swift response. It’s bombs away for risk asset prices.”
We really don’t know which scenario it is (A or B). But we’re not adjusting our long volatility portfolio in a major way right now other than some modest position rotation. If it’s (A) then we will suffer giveback. But we don’t think we’ll revisit the lows in implied volatility now that this event has happened.
This move shows all the signs of being the beginning of something big and we won’t see the same cheap levels to get in again.
If it is (B) then risk assets have a long way to fall. Longer-dated volatility will move substantially higher. Volatilities across asset classes will catch up.
In terms of near-term market signals, the lack of major contagion into asset classes other than equities (volatility in both FX and gold is remarkably muted, rates volatility is moving higher but not by a lot), suggests that there is a very decent chance that it is scenario (A).
However, if markets don’t bounce in the next day or two, then it’s probably (B).
And if we do get a bounce in the S&P but then we get a couple daily closes below last night’s low in S&P 500 futures (2529 overnight low), then it really raises the risk that it’s also (B).