VIX Note Volume Proving Prescient as Volatility SurgesInyoung Hwang and Callie Bost
Turbulence is reappearing in the stock market. For traders in exchange-traded notes that rise and fall with market volatility, it’s like it never went away.
Three of the most popular securities that appreciate when swings in equities increase are poised to post record volume in 2014, data compiled by Bloomberg show. The latest flurry of trading began when markets buckled in October and failed to subside even as markets calmed down in November.
Now, with the Chicago Board Options Exchange Volatility Index posting its biggest increase since 2010 last week, anyone who owns one of the hedging instruments looks prescient. Investors who flocked to the notes even as volatility slid back to a three-month low earlier this month recorded the biggest gains in more than three years last week.
“People just want more exposure to long volatility when volatility is low,” Rocky Fishman, a New York-based equity derivatives strategist at Deutsche Bank AG, said Dec. 8. “They look for ways to get long the VIX. Then we will frequently see flows into levered ETNs.”
More than $1.8 trillion was erased from global equities last week as oil’s drop below $58 a barrel raised concern over the strength of the global economy. The VIX, a measure of trader anxiety that has spent most of the year hovering about 25 percent below its historical average, jumped 78 percent as oil’s impact rippled through financial markets.
Losses snowballed in the U.S. in the last hour of trading on Dec. 12, pushing the Standard & Poor’s 500 Index to a decline of 1.6 percent and sending its weekly retreat to 3.5 percent, the most since 2012. West Texas Intermediate crude capped a weekly decline of 12 percent after the International Energy Agency reduced its estimate for global oil demand growth in 2015 by 230,000 barrels a day.
Equities also reacted to data showing November Chinese factory production growth slowed more than estimated. A 7.2 percent gain from the year before missed the 7.5 percent median estimate in a Bloomberg News survey.
“With the decrease in demand for commodities, it’s impressing upon investors that global economic activity, primarily outside the U.S., is not healthy and not necessarily getting better,” Rich Weiss, the Mountain View, California-based senior portfolio manager at American Century Investment, which oversees $140 billion, said in a phone interview Dec. 12. “With many of the major international economies trending in a negative direction, it does not bode well for the U.S.”
The S&P 500 fell 0.6 percent to 1,989.63 at 4 p.m. in New York. The VIX dropped 3.1 percent to 20.42.
Interest in securities that let investors speculate on how noisy or calm the stock market is have exploded in popularity with the advent of exchange-traded notes tied to futures on the VIX. Strategies include relatively simple hedges against equity losses, such as owning a security that mimics the volatility gauge, a litmus on traders’ appetites for S&P 500 options protection.
Losses in stocks were a payday for owners of volatility notes. With the VIX jumping, the iPath S&P 500 VIX Short-Term Futures ETN gained 30 percent last week, while the ProShares Ultra VIX Short-Term Futures exchange-traded fund rallied 65 percent and the VelocityShares Daily 2x VIX Short Term ETN added 60 percent.
The returns followed a month in which the three lured more than $600 million in fresh cash from investors, the most in 16 months.
Even as the VIX tumbled in November for a second month, shares outstanding in ProShares’ UVXY more than doubled while those in iPath’s VXX ETN and VelocityShares’ TVIX gained at least 26 percent.
Intermittent storms of volatility will be a fixture in 2015 as well, thanks to the end of the Federal Reserve’s quantitative easing program and speculation that interest rates will rise, according to Deutsche Bank, Citigroup Inc. and Barclays Plc.
“The year to come will be very similar to the year that has gone by,” said Olivier Sarfati, the New York-based head of U.S. equity trading strategy at Citigroup. “It can be more volatile because QE has ended. On the other hand, the economy is doing better now. So the question is which will be the stronger factor for volatility? QE ending has created a lot of uncertainty.”
VIX notes aren’t ideal hedging vehicles because investors must contend with higher fees and the risk of being caught off guard by sudden price swoons, said Sean Heron of Glenmede Trust Co. in Philadelphia.
“All else being equal, you’d expect this space to get smaller, but it’s actually gotten bigger,” said Heron, who manages options strategies at Glenmede, which oversees about $27 billion. “When you look year over year, volatility has subsided but these products have picked up in volume.”
TVIX and UVXY have both tumbled more than 55 percent in 2014 as swings in the S&P 500 narrowed to the smallest in at least 10 years through Nov. 28, according to 20-day historical volatility data compiled by Bloomberg. Even as prices slumped, the wave of trading of these securities and money flows this year have caused assets to jump 36 percent in VXX, more than quadruple in TVIX and surge 175 percent in UVXY, data compiled by Bloomberg show.
Higher interest rates in the U.S. and uncertainty surrounding economic stimulus in Europe will drive volatility higher next year than in 2014, said Maneesh Deshpande at Barclays.
“October was a stress test, but even then it worked out,” said Deshpande, the bank’s New York-based head of equity derivatives strategy. “This made people even more comfortable doing the same trade going forward. You’ll see a pattern of these spikes going up and a fall down, so moderate spikes but not extreme spikes.”