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A “Vixing” Puzzle
Equity volatility has been unusually low for much of 2017.
The Volatility Index (VIX), which measures the implied
volatility of S&P 500 Index options and has been viewed
as a barometer of equity market volatility, has drifted to
all-time lows. Over a span of more than 7,000 sessions
going back to the start of 1990, the VIX Index’s average
and median closing values have come out to 19.4 and 17.6,
respectively. It was a rare occurrence for the VIX to
collapse below 10 – there were only 9 such occasions out
of 6,802 trading sessions prior to 2017, or 0.13% of the
times. Year-to-date in 2017, however, there were already
35 sessions with the VIX closing below 10.

Another way to look at the lack of volatility is to tally the
number of trading sessions when the S&P 500 Index had
a daily change of more than 1% in either direction. There
were only 8 such sessions so far in 2017, compared to 48
and 72 such occasions in 2016 and 2015, respectively.

It seems ironic that the market should be this steady with
arguably the most mercurial and unconventional
president in modern history at the helm atop the free
world. Perhaps investors have grown numb to all the
chaos and controversies. It is as if Washington’s
dysfunction and a divided America were just fodder for
the hyperventilating media, and markets were behaving
as if all will be fine when the Republicans pass the tax
reform to prime the pump for the 2018 mid-term
elections. Time will tell if this period of eerie calm is
prescient or misguided.

Unintended Consequences
The decline in market volatility has made shorting against
the VIX futures and various VIX ETPs (exchange-traded
products) quite popular and profitable in recent years.
The net short position on VIX futures has progressively
climbed to new highs over the last couple of years.
Another phenomenon was the rise of “volatility control”
investment strategies, supposedly favored by many hedge
funds and insurance companies. These strategies in
essence adjust a portfolio’s allocation between equity and
cash to maintain a targeted level of volatility at the
portfolio level. In an environment of declining volatility,
more assets would be allocated to equities – the equity
allocation would even exceed 100% when the market’s
realized volatility is below the targeted volatility. On the
other hand, as volatility ticks up, the equity allocation
would be scaled back.

While these strategies have enjoyed strong returns during
this stretch of progressively lower equity volatility, they
may be planting the seeds of a market correction. Market
makers and dealers on the other side of the growing short
VIX trades would need to employ various S&P 500 option
strategies to hedge their long VIX positions. There is the
concern that a decline in the S&P 500 Index could trigger
adjustments to these hedging positions that would
exacerbate the market decline. Similarly, should volatility
suddenly spike up, the aforementioned volatility control
strategies would be cutting equity exposures
concurrently, which could amplify the market decline
similar to the downward selling pressure that the so-
called portfolio insurance products generated during the
crash of 1987. We wonder if any investors and regulators
truly appreciate how these strategies, in concert with
various rapid fire trades generated by machine-learning
based algorithms, could impact market movement and
liquidity should there be an exogenous shock. Only time
will tell.

Fear vs. Greed
There is an adage that one should be fearful when others
are greedy and greedy when others are fearful. Judging by
the depressed levels of the VIX Index, the enthusiastic
speculation over bitcoin as well as other variants of
cryptocurrencies, and surveys that indicated strong
investment sentiment, it is clear that greed has been on
the rise. Can this euphoria continue for a while longer? Of
course. However, in our opinion, the combination of
elevated investor complacency and a tightening Fed
makes the market vulnerable to a pullback, though the
timing of it is hard to predict. The aforementioned issues
with various trading strategies could further add fuel to
fire in the event of a market decline. That said, with the
macro and earnings backdrop remaining positive, we
would view potential selloffs as a buying opportunity
rather than the start of a protracted market downturn. •

MONTHLY MARKET REVIEW NOVEMBER 2017 3
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