This article first appeared in EQDerivatives' subscription Commentary & News service.
Market participants are eyeing opportunities in VIX/VSTOXX® spreads, 2019 dividends and alternative risk premia investing as volatility is expected to remain high following its dramatic revival last month. Vol levels have been elevated since the CBOE Volatility Index-led selloff on February 5, which saw a 100% increase in the VIX, while the EURO STOXX 50® Volatility Index saw its biggest one-day surge since the Sept. 11 attacks in 2001. Georgia Reynolds reports.
“There are three key reasons to expect that implied volatility will not move down to its lows again, that is higher U.S. interest rates, loss of capital from vol sellers and the VIX term structure remains inverted,” said Adam Rudd, portfolio manager at Aberdeen Standard Investments. Those systematically rolling short VIX futures will have negative carry until the curve normalizes and becomes upward sloping again, he said.
The VIX has been increasing since late January, following record highs seen in the S&P 500. On February 5, the VIX was trading at a one-year high of about 35 during U.S. afternoon trading hours, following record volume in VIX options the week prior, with 4.3 million contracts changing hands, according to CBOE Global Markets. This was followed by a record of 332,000 VSTOXX® Futures contracts traded, according to Eurex. “What happened to the VIX is more technical than fundamental,” Rudd said. The fundamental indicators suggest vol will not stay at the levels of last month. Credit spreads remain close to cycle tights, rates volatility is still below historical averages and economic and earnings growth is strong, he said.
Looking across strategies, two key areas saw significant moves down in February, according to Ben Redmond, a director in quantitative investment strategy structuring at Barclays. “Volatility was very heavily impacted, and that is the same whether it was option based strategies, variance swaps, and most of all being short VIX futures,” said Redmond. “Our message to clients is always [that] vol selling is of course a wellknown risk premia with a clear rationale behind it, but you are effectively selling insurance to other market participants and at some point that insurance pays off and in this case we saw it pay off,” he said. CTA-like strategies also saw pronounced moves on the downside at this time given their risk-on position and high leverage, he added.
Now, there is an opportunity to sell the VIX as a relative value position against buying the VSTOXX®, Rudd said. The further out the curve investors go, the more likely the fundamentals will reassert themselves, he said. The persistence of some of these technical drivers creates greater risk at the front of the curve, he added. “If you trade the spread of the first month contract, it is much more volatile. If you trade the spread of the six-month contract, it is much less volatile. The reason to expect the [SX5E] vol to be higher than the [SPX] vol is one key reason, and that is the correlation within the indices,” Rudd said. The SX5E has 50 constituents, making it more concentrated as opposed to the SPX which has 500. “The SPX is more diversified across different sectors and different companies, so even if we assume the same average single stock volatility across European companies and U.S. companies, the correlation difference justifies an expectation for higher volatility on the SX5E and that is worth a positive number on the spread,” he said. Any opportunity to buy European volatility below S&P 500 volatility is a good opportunity, he added.
Right now, the term structure for the VIX/VSTOXX® is exceptional, according to Hervé Guyon, equity derivatives flow strategy and solutions at Societe Generale. “The volatility of the VIX is still super expensive. We think at SocGen that it might be a bit too expensive given that most of the short exposure from the VIX [exchange-traded products] has disappeared right now,” he said. This leveraged exposure is what exaggerated the move of the VIX, he added. “This is why the VIX volatility is very high compared to the VSTOXX® which means that we still like the trade whereby you buy the calls on VSTOXX® and sell the calls on VIX with a higher strike for flat premia,” he said.
In terms of pure VSTOXX®, it is quite interesting to see that the term structure has remained extremely flat, Guyon told EQDerivatives. “Previously, we had seen the term structure steepening much quicker than what is currently occurring and therefore some of the flow that we have seen in the wake of the selloff was investors buying downside on the VSTOXX® either via puts, or put ratio,” he said. This can show there is uncertainty regarding the monetary policy and fear of acceleration of the hiking cycle both in the U.S. and Europe. “If you look at the first future on VSTOXX® we were just above 10 vol points before the selloff, I think it is unlikely that we see the VSTOXX® and the VIX back to the lows we saw at the end of 2017.”
According to Rudd and Guyon, volatility is expected to remain at higher levels throughout this year. “If the macro situation keeps on surprising on the upside then it is very unlikely that we will see low vol coming back because it will trigger a significant bond selloff both in Europe and the U.S.,” Guyon said. Over the last five years there has been a negative correlation between bonds and equities. Throughout the selloff investors didn’t need to buy as much volatility as today to get protection since the bonds had a better diversifying property for an equity portfolio, he said. In the context of hiking rates and tapering, the equity/bond correlation regime has shifted from negative to positive, this means investors have to hedge their long equity exposure. “I think there will be a renewed demand for hedging in the option space on the equity indices because you cannot rely on your fixed income exposure to hedge this equity leg,” he said. This is the key reason Guyon believes the low vol regime has ended. However, if there are no major surprises on the economic front the low vol regime could return due to flows coming from the systematic vol selling strategies which had reached unprecedented volumes in 2017, he added.
Elsewhere, dividend futures corrected in the selloff in equities, however there is very low risk associated with 2019 dividends right now, according to Rudd. “You still have an option on higher growth, so there is an opportunity in European dividends futures,” he said. “There is more risk the longer out the curve one goes, so I would say the potential return is arguably greater, but the risk is also greater and so it is a better sharpe ratio trade to own the shorter dated div futures,” he said. “With the earnings season coming to an end, the beta of Dec19 div vs. SX5E is likely to decrease and will become more and more bottom-up driven. While it is not our main scenario right now, an early reshuffle of SX5E index in June cannot be ruled out and could impact SX5E dividends,” Guyon said.
The recent move has been a good case for investing in alternative risk premia and showing how those premia can diversify client portfolios, according to Redmond. “We have seen a lot of our clients (in) long equities [and] long bonds… This trade has been quite painful with both equities and bonds selling off at the same time,” he said. A key message from last month is that the risk premia strategies remain de-correlated to each other, he added. “This is exactly what we are looking for when we market these alternative risk premia strategies to our clients and when we construct portfolios of them,” he said.
The strategies are capturing different sources of returns and in a selloff environment, like February, there isn’t the same impact on performance across those types of strategies, Redmond said. “Some of the takeaways that we saw was that it is always good to try and diversify across different markets and different geographies. With Feb, the U.S. was impacted more than other regions, and this reiterates to our clients the need to diversify across markets if they are doing vol selling strategies and also diversifying those strategies across different instruments as well.”
Outside of CTAs and short vol, performance has been positive, Redmond said. “Our clients are invested across a range of our strategies and were pretty happy throughout the selloff,” he said. For example, strategies including credit carry – which most people would associate with being a risk-on strategy, performed well, along with long-short equity factor implementations and a number of commodities strategies. “I would argue that you want your different premia capturing idiosyncratic risk, like some of the commodities strategies do, and not all being very macro risk related so that in market corrections, such as we saw recently, you can make returns from different places as opposed to just having something that is very correlated to the major asset classes, e.g. equities and bonds.”
Last month, market participants told EQDerivatives that alternative risk premia users are likely taking their first steps toward revisiting the ARP landscape amid the return of vol. However, Redmond argues that this is not a bad period for ARP because it shows the merit of these types of strategies. “We are definitely seeing increased interest from clients, we have seen clients putting on or upsizing RP trades and we expect that to continue,” he said. “If you build the strategies in a thoughtful way and understand the different risk of those strategies that can be very beneficial to add to your traditional portfolio. So, in some ways this move has [been a good] argument for these types of ARP investments,” he said.
|Georgia Reynolds is a reporter at EMEA at EQDerivatives, based in London.|
A recent graduate from City University London, Georgia has been studying and producing print and multimedia journalism for five years.
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