As pension funds and endowments struggled to find yield during an unrewarding decade of historically low rates, several major institutions began dabbling in complicated (and not so complicated) options contracts in order to take advantage of the unusually long period of low volatility since the 2009 lows. In fact, until last Monday, the S&P 500 had gone 404 consecutive trading days without a 5% correction - the longest such streak in nearly 60 years.
And with what appears to be the return of whipsaw action - as anyone who rode out last week's 97% drop in XIV and record surge in the VIX can confirm..
... bets on low volatility are beginning to look problematic - as the risk of an unwind threatens to derail the 7-8% annual returns required by pensions to meet obligations.
As we first noted in February 2016, institutions began quietly generating so-called current income by selling market puts as stocks charged ever-higher - the proverbial collection of pennies in front of a steamroller strategy - with such popular names as the Harvard Endowment and state pensions funds for the State of Hawaii and Illinois among the most bizarre offenders.
Overnight, the WSJ reminded us of this idiotic "strategy":
The $16.9 billion Hawaii fund in 2016 began earning money selling “put” options—essentially a bet that markets would stay calm or rise. When markets fall, Hawaii is on the hook to pay out.
To that end, an increasing number of Wall Street firms have been specializing in volatility-linked strategies for pension funds and other large investors. As an example, Neuberger Berman's U.S. Equity Index PutWrite Strategy is one such product which sells puts on stock indexes.
It wasn't just S&P puts.
“There’s a tsunami of money going into” these types of strategies, said Don Dale, a managing member of consultant Equity Risk Control Group. The firm advises large pension funds and endowments.
Pension funds, endowments and family offices took other steps, including selling VIX futures and options, selling options on the S&P 500 or other indexes and selling options on individual shares or other indexes.
In some cases, pension funds were even long inverse VIX; and last Monday they suffered a loss greater than 90% in one day.
In a document prepared for an Illinois pension, the firm argued that behavioral biases in financial markets mean investors “ultimately overpay for protection.” The Neuberger Berman options products have attracted about $3 billion over the past two years.
"But the strategy suffers losses when stocks fall," The Journal "explains" without an ounce of sarcasm. "So far this month, the fund has lost 4.37%, through Feb 12, though that tops a loss of 4.52% for its benchmark, a mix of puts on stock indexes and compares with a 5.90% loss for the S&P 500 through that date."
Neuberger's not worried though. “The efficacy of these strategies manifests itself over months and quarters,” said Doug Kramer, who oversees the PutWrite strategy. “Everything’s functioning as designed. We’re happy to have higher volatility and be able to underwrite higher option premiums.”
That said, as the chart below illustrates, bets on low volatility - estimated by Alberto Gallo, a portfolio manager at Algebris Investments in London, to be over $500 billion, and by Fasanara Capital to be as much as $22 trillion, may leave quite the mark as markets grapple with "exciting" returns that saw the Dow Jones travel more than 22,000 cumulative points last week when you add up each day's trading range:
It's what happens when volatility is unleashed that is the greatest risk: "Our fear is when these strategies unwind,” said Algebris' Gallo.
Last week's we got a preview of just that.
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Meanwhile, whether due to prudent asset management or blind luck, Harvard University appears to have been spooked out of a bet against volatility - as the Harvard Management Co. sold 121,000 shares of the ProShares Short VIX fund SVXY before the end of 2017 - after holding it just one quarter. (they notably also sold out of HYG, the infamous junk bond ETF which is next to blow up after the market's next mini crash).
Perhaps last November's 5% drawdown in two weeks was a bit too spicy for crimson portfolio managers:
With central banks gradually withdrawing their financial safety nets and interest rates looking like they're on the cusp of another march higher - volatility may be back for a while, and with it, a $500 billion (or much higher) unwind of low-volatility strategies that would make last week's "historic" Dow crash seem like a dress rehearsal.
As with most "great" strategies, it works until it doesn't.
For now, however, it's clear that nobody has learned any lesson.
As we first reported over the weekend , the ProShares Short VIX fund, which posted a 97% drop in net asset value last week from its high price in January, has since rebounded. On Tuesday, it closed at $11.29, up from a low of $9.58 on Feb. 8, and its market value is now nearly $800 million, up from $300 million just last week.
“People are jumping back into this product again,” said Pav Sethi, chief investment officer of Gladius Capital Management, an investment firm focused on volatility strategies, “despite the clear structural risks."
Of course, with central banks now "certain" to bail out the market after even a modest 10% correction, can anyone blame them?