Volatility Hedge Fund Sees Bull Market in Fear as Bets Jump

  • Trading of VIX futures is on course for a record year
  • Investors are paying highest prices since 2012 for protection

Beneath calm stocks, the volatility market is jumping.

Take futures on the CBOE Volatility Index, whose volume surged 50 percent this month and is on pace for a record year, according to data compiled by Bloomberg. Belying the lull evidenced in the VIX itself, which has traded almost 30 percent below its historical average in September, six-month contracts on the index are priced about 40 percent higher and last month the gap hit its widest since 2012.

All that’s been money in the bank for Christopher Cole, the Austin, Texas-based fund manager whose Artemis Capital Management is known for stark pronouncements like “volatility is an instrument of truth.” His flagship fund gained almost 16 percent this year through August, compared with a 0.7 percent decline in its benchmark, the Eurekahedge CBOE Long Volatility Index.

“We are in a new bull market in fear,” said Cole, the chief investment officer of Artemis, which has about $95 million in assets dedicated to its core volatility strategies. “We are in the second-longest bull market in history. There is the question of whether this is a healthy market or something that has been artificially propped up.”

Volatility was on display on Thursday, when the VIX shot up as much as 27 percent and U.S. stocks tumbled amid growing concern Deutsche Bank AG’s woes will spill into the financial sector. The lender lost 4.1 percent in Germany on Friday, after a Bloomberg News report that about 10 hedge funds clearing derivatives trades with the firm have moved to reduce their financial exposure with Deutsche Bank.

The VIX rose 3.5 percent at 10:06 a.m. in London, while its European counterpart, the VStoxx Index, jumped 8.5 percent.

The episode was another break in the prevailing calm that helped the S&P 500 climb as much as 7.2 percent in 2016 at its highest point, even as earnings fell and economists lowered their estimates for economic expansion to 1.5 percent. In September, almost 270,000 VIX futures traded on average each day, boosting the mean for the year to more than 210,000. That compares with between 182,000 and 190,000 on average in the past two years.

Part of the surge in VIX futures trading is due to the fact that the market for volatility products has matured. Investors are increasingly using them to protect their stock holdings, and the hedging of some exchange-traded notes tracking swings requires buying and selling futures. Shares outstanding on the iPath S&P 500 VIX Short-Term Futures ETN, the most used of such products, reached a record just weeks ago.

Investors are also preparing for more turmoil because volatility has been particularly tame. The VIX has been below 15 most of the quarter and reached its lowest level since 2014 last month. While its futures are also low, their premium relative to the VIX -- about 9 percent above the one-year average -- shows investors are willing to pay up for protection. They’re also using options, with the number of contracts wagering on a VIX rise hitting its highest level since May relative to those betting on declines.

Cole says the reason why the slope of the VIX curve -- which compares the volatility index today to levels priced in for future months -- is steep is because investors are no longer counting on central-bank support to the extent they used to. The Fed is preparing for another rate hike, and the European Central Bank has signaled limits to its willingness to keep loosening monetary policy.

“Last year, investors were saying, ‘Don’t worry, central banks will save the day, there is no way they are going to let the market keep going down,’” he said. “This year, they know there is risk, saying ‘I know they could let markets decline 10 percent and I could be hurt, so I better hedge.’”

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