markets-magazine

Why Is Volatility So Low?

We checked in with seven experts, including a Nobel laureate. They cited ‘Minsky moments,’ chaos and crowded trades.

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Volatility was one of the never-ending talking points of 2017. Hardly a day went by without stories citing the almost eerie calm in U.S. stock markets. The Chicago Board Options Exchange Volatility Index, or VIX, finished the year with the lowest average daily level on record. During the course of the year, we saw the market’s fear gauge set a new record low when it closed at 9.14 on Nov. 3.

Want more perspective? Try this: Arrange all the trading days this millennium from lowest to highest by the value of the VIX that day. The first 41 entries on that list would all be from 2017! Fully 80 of the top 100 calmest days since the turn of the century were in this past year.

It’s not as if there wasn’t anything to worry about. The Federal Reserve’s Partisan Conflict Index, a measure of political disagreements with data stretching back to 1981, hit its highest point on record in March. The country endured the most expensive hurricane season. Threats of a federal government shutdown came and went. Not even a nuclear showdown with North Korea could raise investors’ collective pulse. The market was simply unflappable.

But while we’ve all been told time and again that volatility is low and complacency is high, we’ve gotten little in the way of an explanation as to why. What’s changed? Should we expect a return to normal, or have new developments put a cap on how crazy the market can really get? Is there still value in the short VIX trade? Does this end with a bang or a whimper? We asked seven experts for their takes on why volatility has been so low.

Has the volatility regime changed in some fundamental way?

“I feel like we think of low volatility as a paradox because of the many random events coming out of Washington. But I’m convinced that it’s because they aren’t real events. It’s like fake news. I don’t think the market is waiting for some great event from the administration. It’s just working on its own. What we think of as important really isn’t. It’s not an accident that this notion of fake news has been embedded.” —Robert Engle, Professor of Finance at New York University and Nobel Laureate

There must be some real drivers, though?

“No one can see any signs of an imminent recession. And of course quantitative easing contributes as well.” —Simeon Hyman, Head of Investment Strategy at Proshares Advisors LLC

Any other underlying reasons?

“There are good cases to be made for why realized volatility is low—and can remain there. Stability in interest rates is the bedrock around which all other stability is built.” —Dean Curnutt, Chief Executive Officer of Macro Risk Advisors LLC

OK, so maybe we are in a different era?

“Equity prices over long periods of time have been more volatile than their underlying fundamentals would warrant, so perhaps the explanation is that the historical levels of volatility were artificially high as much as the VIX is now artificially low.” —Eddie Perkin, Chief Equity Investment Officer at Eaton Vance Corp.

What about all the flows into ETFs?

“Passive investing is a consequence of reduced fear but also a mechanical cause for lower volatility. With the same logic, smart beta, volatility controls, shifts in annuity contracts, structured products issued abroad, to name a few—all have mechanically pushed volatility lower by substituting rules and algorithms for ­passionate and volatility-generating human decisions. Let’s not forget, however, that all this could work because liquidity was high and corporate earnings were very strong. Take away one or both, and everything changes.” —Daniel Benchimol, Senior Portfolio Manager at Wolverine Asset Management LLC

Then what’s the upside of selling vol?

“Lately, at multiyear low levels of implied volatility, short sellers of the VIX futures can expect most gains to come from the roll down of the position rather than from a further repricing lower in the absolute level of the VIX futures curve.” —Sarah Dahan, Portfolio Manager at BlueMountain Capital Management LLC

The proverbial picking up nickels in front of the steamroller?

“The biggest responsibility to the trade is to know in advance that it will go against you at some point. It’s inevitable that vol will spike and you will lose money. In my view, it is important that you are overcollateralized and that you have a long-term program in place. Tactical trading of short VIX is very difficult.” —Doug Kramer, Co-Head of Quantitative & Multi-Asset Class Investments at Neuberger Berman

How difficult is that trade?

“There are a few different formats of the trade, but in general, when selling VIX futures, investors should be mindful that there could be meaningful losses and large margin calls if VIX spikes, so properly capitalizing the trades is essential.” —Sarah Dahan

Is it getting crowded?

“We’ve actually already seen the effects of the crowdedness of this trade on a very small scale every time uncertainty mounted these past three years. VIX was very quick to rise by large amounts on numerous short-lived occasions. These events may not seem like much, but they were completely disproportionate compared to the rest of the equity market, giving us an idea of how a selloff could play out next time.” —Daniel Benchimol

How do you see a selloff playing out?

“We also are concerned about the success of the short volatility trade and the potential that it has become crowded. These kinds of trades tend to be unwound quickly when conditions change, potentially amplifying volatility. Given how strong corporate profits are and how committed the central banks remain to guiding the market along, this low-volatility period could last a while longer. That said, we are in the ‘Minsky moment’ camp of believing that stability, especially when prevalent for a lengthy period of time, ultimately creates instability.” —Dean Curnutt

Sounds bad.

“Similar to the portfolio insurance dynamics in 1987, some anticipate a scenario where a volatility shock could trigger a negative feedback loop in equity markets. While it is unknown what would trigger such an event, the end result would be certain strategies forced to sell into weakness. The fear is that selling begets additional selling and the market enters a liquidity vacuum where sellers cannot find buyers of risk assets.” —Eddie Perkin

Uh-oh.

“I think there are many inexperienced traders shorting VIX and that when vol does spike, they could panic and seek to cover their shorts. This short covering could in turn cause VIX to go up more than it otherwise would. With that said, this technical condition wouldn’t last long and volatility would eventually mean-revert to normal levels. Given how we think about the vol world, we could profit from this.” —Doug Kramer

What about technology?

“One of the notable achievements in recent years is the advent of computer participation in the marketplace, from AI to algorithmic trading to the ability to generate and manage new strategies. While some of these shifts remain controversial, they all provide the addition of a new layer of order between human passionate decision-­making and the market. In fact, one could argue that volatility’s long-term mean should come down because of that. Is it to say that we won’t see volatility ever again? Of course not. We have simply entered a new era where volatile events get digested faster, at the speed of computers, but we have not eliminated chaos.” —Daniel Benchimol

Chaos?

“One of the most obvious events would be an indictment of the president. I’ve asked my friends, though, and they don’t seem to think it’ll be a very volatile moment. Maybe that’s consistent with the idea that volatility, or lack thereof, comes from Washington. I think more about geopolitical events: deterioration of conditions in the Middle East or North Korea. What really scares me the most is a cyberthreat. That countries could get into our computer system. That could produce a lot of volatility and damage our system.” —Robert Engle
 
 Kochkodin is a managing editor at Bloomberg News in New York.
 

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