Earlier today we brought you the latest from the best analyst on the Street, Deutsche Bank’s Aleksandar Kocic – you can, and should, read it here.
For Kocic, the reflexive relationship between the Fed and markets has served to create a communication loop from which there is effectively no escape. He couches this in terms of transparency.
“Transparency forces everything inward and numbs the awareness of anything that resides outside of the existing channels of informational exchange, making it difficult to have a non-consensus view,” he writes, adding that when this dynamic becomes entrenched, “a long term vision becomes progressively more difficult to construct and things that take more time to mature receive less and less attention.”
Policy becomes a kind of rolling plebiscite that “confirms and optimizes only what already exists.” Unless the Fed decides or is forced (neither of which is likely) to stop being transparent or to effectively stop participating in a real-time referendum with market participants, no one can take a long-term view and thus “volatility is unlikely to sustain a bid.”
In what is either a testament to this or, if you don’t believe anything meaningful can be divined from positioning, is apropos of nothing, the net spec VIX short hit a record high through Tuesday.
That brings us to a new piece out from SocGen. While what you’ll read below won’t win any prizes for profundity (i.e. this ain’t a Kocic note, so adjust your expectations accordingly), it might interest those who are more inclined towards analysis that doesn’t make you draw on your inner philosopher.
How many engines is the “short VIX” plane now running on?
The profitability of a classic short VIX trade depends on three factors – 1) steepness of the contango (the spread between the first and second VIX futures), 2) absolute level of VIX future (1M constant maturity) and 3) the realised vol of VIX (delivered volatility of 1M constant maturity future).
Contango has been by far the largest contributor to the short VIX profitability since 2011, as VIX has remained low overall – delivering an average compounded monthly return of 5%. We have noted in the past the extent to which VIX contango is driven by the flow on long VIX ETPs: more investment in long VIX ETPs ironically cause further bleeding as more inflows cause more buying of the second future and more selling of the first, causing the term structure to steepen and carry to become more prohibitive (left-hand chart below).
Headline volatility has been the second-largest contributor with periods of negative and positive contributions. The average contribution is 0.5% compounded carry per month on average, but that number is reduced considering the fact that headline volatility has led to negative returns in three out of eight years since 2010. Timing is tremendously important here and selling after a VIX spike is the golden (but risky) rule.
The wild-card is the realised volatility of VIX, which historically helps the compounding of return when it is low but is detrimental when it is high. Forecasting future realised volatility of VIX is obviously a difficult task, but when looking at what the market is pricing through implied volatility of VIX options, it has rarely been so high (right-hand chart below).
Ultimately, investors can choose to second-guess fund flows, but once headline volatility reaches the lows, the proverbial short VIX “plane” will again be running on a single engine – carry – which itself is reflexively determined by fund flows.
We acknowledge that selling pressure on vol can continue owing to more investors looking to benefit from the carry on the short vol trade in a yield-deprived world, but we see enough reasons to be wary. The expensive skew in US equities could be a sign of an under the surface change in the composition of vol sellers and more sophisticated investors being reluctant to sell the second order tail-risk measure. The volatility episode in August is a good illustration of the potential losses on the short VIX strategy – XIV and SVXY have still not recovered their levels from end-July despite VIX back at sub 10 levels.