Is ‘target vol’ behind the stock market gyrations?
As Fortune notes:
The average volatility rate for 2017 was lower than every single trading day from Dec. 22, 1995, to June 20, 2005. The VIX finished below a level of 10 — super quiet! — on only nine days before May 2017 and 68 days since.
But that all changed in the hectic trading week from Friday, Feb. 2 through Friday, Feb. 9. During the record 1,175-point crash of the Dow Jones Industrial Average Feb. 5, the assets in two exchange-traded volatility products—the ProShares Short VIX Short-Term Futures ETF, or “SVXY,” and the VelocityShares Daily Inverse VIX Short-Term ETF, better known as the “XIV”—fell from $3.6 billion to just $135 million. Credit Suisse ended up announcing the next day that it would buy back the outstanding shares of the XIV, which had fallen 93 percent since hitting $2 billion in mid-January.
Now, many on Wall Street are pointing the finger at one of the largest buyers of these “short vol” products – the life insurance industry. As part of its recovery from the financial crisis, which saw variable annuity accounts hit hard, many insurers have redirected customers to so-called “managed volatility” funds that automatically shed risky assets when volatility spikes.
According to the Financial Times, the hedge fund Bridgewater estimates life insurers have invested roughly $350 billion in managed volatility accounts, while Oliver Wyman analysts note life insurers have been forced to sell off $80 to $100 billion of stock futures in recent days to account for the run-up in volatility.
‘Since these funds trade out of equities during downturns they can, ironically, actually increase market volatility because so much money is moving out of equities as a result of the volatility controls,’ said Steven McDonnell, [variable annuities specialist Soleares Research] founder. ‘That’s what people are concerned about.’
Indeed, industry consultants have been recommending target volatility strategies for a number of years. In a 2016 presentation for the Society of Actuaries, Jon Spiegel of Deutsche Bank lays out a strategy of both buying volatility instruments and hedging those with vanilla options, with a plan to buy puts when volatility is falling or sell puts when volatility is rising to hedge the crash risk of an insurer’s target volatility liability. This strategy would create a position where traders could enjoy a positive carry, long skew, long convexity and deep tail-risk protection.
“Target volatility strategies exhibit less skew as well as more predictable volatility than pure equity. Hedging strategies should benefit from both of these characteristics,” Spiegel writes.
So do the events of recent days demonstrate that insurance is potentially a larger source of systemic risk than is generally appreciated? And does this counsel against recent moves by the Financial Stability Oversight Council to de-designate firms like MetLife and AIG?
It’s first useful to emphasize just how small the $350 billion “target vol market” is as a percentage of the nearly $30 trillion U.S. stock market. Life insurers selling off $100 billion of equities cannot feasibly be fingered as the sole – or even a particular major – cause of the recent correction.
It does appear there may be more of a feedback mechanism between relatively small moves in volatility instruments and the broader volatility index, which could spark automated trading programs to behave strangely over the short term. But that indicates broader problems with the bots that go far beyond the insurance industry.
It’s also important to note that the move toward “target vol” strategies has not arisen out of purely organic market forces, but instead come largely in response to new regulatory dictates. In particular, note Patrice Conxicoeur and Karine Desaulty in a February 2016 white paper for HSBC Global Asset Management, the decades-low interest rates of recent years have combined with regulatory regimes like Solvency II to create a “perfect storm” of pro-cyclical investment behavior by insurers. Such regulatory regimes require that insurers use value-at-risk or other metrics to demonstrate they’d be able to withstand an enormous upswing in volatility.
“It is thus particularly unfortunate that such solvency regimes are coming on top of accountancy reforms pushing for more ‘market consistent’ (read: ‘marked to market’) valuations of assets and liabilities, which will inevitably lead to more volatility in financial results, to the dismay of CFOs and shareholders alike,” Conxicouer and Desaulty write. “For insurers, volatility has thus become public enemy number one, and equities its main conduit. Pressure has never been so great to minimise volatility, given stakeholders’ growing intolerance of uncertainty.”
And once again, we are left to ponder how rules intended to curb and manage systemic risk all too often instead end up creating it.
Image credit: Vintage Tone
