Low VIX volatility, long VIX volatility

The VIX volatility index has hit historically low levels by several measures, invoking memories of past episodes when volatility spiked higher. This week’s Simply put delves into factors driving volatility to depressed levels, asks if today’s situation could be ripe for a bounce and considers the investment implications. 

Volatility recedes to lows

The recent resumption of the equity rally has significantly impacted implied volatilities and CDS indexes, both of which are commonly used as markers of risk aversion. For volatility, there is an additional layer to consider: following a surge in March 2024 to more than 20%, the volatility index (VIX) has since receded to one of its lowest points, around 12%. Current levels are roughly aligned with those observed in December 2023 when the November equity rally began to gain momentum. 

To any seasoned market observer, this scenario may evoke memories of 2017, when volatility hovered around 10% before dramatically spiking in 2018 in the so-called VIX complex burst. Is today’s situation comparable? And what are the investment implications? 

Our answers, in Simply put mode. 

We’ve been there before

Over the past decade, the Quantitative Investment Strategies (QIS) industry has grown substantially. Within this area, short volatility strategies have garnered significant investor attention, in spite of the VIX complex burst in 2018. In February 2018, the VIX index rose from sub-15% levels to 50% in the first few days of the month, leading short VIX strategies to lose more than 80% over that period. 

In the realm of finance, it's wise to avoid the adage ‘this time is different’ as history can have a way of repeating itself. Currently, there's a palpable resurgence in short volatility narratives as evidenced by the very low level of the VIX index. 

Figure 1 illustrates the average VIX index in relation to various growth environments, as measured by our nowcasting indicators detailed at the end of this document. During what are now referred to as soft landing economic environments, previously known as Goldilocks periods, the VIX typically reverts to around 17% on average. Notably, the year 2017 recorded even lower figures. Conversely, hard landing periods often see VIX levels near 30%, while no-landing periods tend to align more closely with the long-term average from 1990 to 2024. 

Today's situation appears truly exceptional. With the current first VIX contract around 12%, implied volatilities are particularly low, especially for short-dated options, in our opinion. This trend can be partially attributed to the impact of 0DTE options¹, but that's not the sole factor. There appears to be a renewed interest among retail investors for short volatility solutions, suggesting a shift in market dynamics and investor sentiment. This trend warrants close observation, as the allure of high returns often comes with increased risks, especially in volatile market conditions.

FIG 1. VIX index level as a function of macro conditions

Source:  Bloomberg, LOIM. For illustrative purposes only. As at May 2024.
 

Collapsing vol

The currently very low VIX levels indicate a scenario where realised volatility is collapsing. Historically, over the long term, implied and realised volatilities tend to move together. The bull market, like that observed over the past six months, typically features retreating earnings risk, which consequently leads to a decline in the demand for option insurance; the VIX acts as a barometer for this trend. Currently, this decline in implied volatilities is excessive compared to history, and this can be observed in the divergence between the short volatility trade versus an equivalent long equity index position.

The left-hand chart in figure 2 highlights the comparison: from 2006 to 2021, the short volatility trade achieved a Sharpe ratio of 0.55, while the long equity position (S&P 500) registered a 0.46 Sharpe ratio, indicating nearly identical risk/return profiles. 

More recently, however, from 2022 to 2024, this performance comparison has diverged dramatically, with short volatility achieving a towering 1.1 Sharpe ratio compared to a mere 0.13 for long equities. This isn't merely a transient phenomenon; the return to short volatility strategies as a means of enhancing equity premium capture has surged in recent quarters. 

FIG 2. Sharpe ratio comparison between short vol and long equity strategies (left) and short vol ETF increase in AuM (right)

Source:  Bloomberg, LOIM. Right-hand chart has been gathered from the list of all Short-Term Volatility ETFs traded in the USA with a short volatility strategy which are currently tagged by ETF Database. For illustrative purposes only. As at May 2024. Past performance is not an indicator of future results.

ETF flows stabilising

Where does this performance originate? At least partially, it can be attributed to ETF flows, which probably reflect a broader market trend and demand for other products chasing the same return stream, as shown in the right-hand chart in Figure 2. This shows that since 2022, there has been approximately a USD 5 billion increase in assets under management (AuM) for an investment vehicle specifically targeting retail investors. 

Given that these flows have recently stabilised and with the VIX reaching the lows, we question whether it is still an opportune time to continue favouring going short volatility over long equities? From both cross-asset and single asset class perspectives, particularly for convertible bonds, we believe that chasing this trend elicits increasing risks and potentially disappointing performance.

What this means for All Roads

Since November last year, our All Roads strategy has been actively increasing its global market exposure, albeit not excessively, and notably adding to its cyclical traditional risk premia: equities and commodities. As a natural consequence of our asset allocation mechanism, our ’long volatility’ pocket has also seen an increase in exposure, serving as a hedge against rapid and sudden market drawdowns. This segment includes long equity volatility strategies, amongst others. 

Given the current abnormally low levels of volatility, the situation presents more of an opportunity for our strategies rather than a headwind. Our nowcasting indicators have recently highlighted a fading US economic cycle that has generated negative surprises, suggesting that maintaining such cost-effective hedging policies should bolster our ability to provide stable returns in the coming months. This strategic positioning underscores our goal to maximise safeguarding of investments while capitalising on emergent market conditions to enhance overall portfolio performance.

What this means for convertible bonds

After being a source of significant performance for convertible bonds during the COVID period, volatility detracted from convertible performance in 2023. Today, the valuation of the asset class is at a multi-year low (figure 3) and represents an attractive risk/reward opportunity, in our view. Realised market volatility is already so depressed that a rebound is more likely during a period of uncertainty, rather than a material shift lower. 

In the meantime, the bond component of convertible bonds provides investors with attractive yield possibilities against the backdrop of higher rates, while the embedded equity option provides convexity with stock markets at potentially compelling levels.

FIG. 3: Convertible bond implied volatility vs realised volatility of the underlying shares

Source: Bloomberg, LOIM, FTSE Global Focus Euro Hedged. For illustrative purposes only. As at May 2024.
 

Simply put, short VIX strategies have been buoyed by retail flows and currently show abnormalities. We are content to position ourselves on the opposite side of the trade in some of our strategies.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our growth indicator has increased across all 3 regions throughout the week, with a notable surge observed in the US, specifically in relation to housing data
• The inflation nowcaster has shown an upward trend in the US, China, and the eurozone. A surge in housing data in China this week has contributed to an elevated indicator in that region as well 
• Similar to the inflation scenario, the increase in housing sector data in China has resulted in a higher monetary policy nowcaster. In the US and the eurozone, the nowcaster has also risen, but to a lesser extent

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
 

source:

1  ODTE stands for zero days until expiration and refers to options that trade and expire that same day.

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