The theory that volatility ETPs are somehow going to have adverse consequences on the market has been a popular theme for a month or two now at least. I’ve tried to show why this this idea doesn’t make sense twice; when it comes to zombie ideas, sometimes you have to just keep trying. If you want to claim that the increased volume in volatility ETPs is causing the VIX tail to wag the SPX dog, you owe the world the following sort of evidence: show an increase in S&P 500 vega exposure in some product, whether exchange-traded or not, that at least correlates in time with the rise in volatility ETP vega.
If you buy $100 of long SPX vega from me in the form of VXX shares, as the issuer I will turn around and hedge my short vega exposure with something else: VIX futures, VIX options, OTC SPX variance swaps, SPX options, or something related. Let’s say I buy $100 vega in VIX futures to cover my short VXX exposure as the ETN issuer. If you keep coming back to buy more vega and I keep hedging, eventually I will exhaust the “natural” supply of VIX futures, SPX options, and related products, right? That’s theoretically possible, but all of the available evidence suggests that we have not even teased the outer edges of those limits, were they to exist (which I doubt).
Here’s well-known options author Larry McMillan in a recent note:
This week, the March-April spread has widened about 30 cents per day, right near the close, as the ETN managers of VXX et al are forced to sell March and buy April under the terms of the contracts. As we’ve stated before, all this money pouring into VXX, TVIX, VIXX, VIXY, and others is not going to end well. They are paying ridiculous prices for these futures, and when the music stops (most likely in a sharply declining market), they may find that the market goes down and their ETN goes down (even if $VIX goes up). But for now, they continue to control this market via their “rolls” and via new purchases of the shares of these ETN’s.
There’s actually no evidence at all that activity in volatility ETPs poses any kind of unusual risk – in fact, the data all go in the other direction. Here’s a chart of the total vega outstanding since March 2011 in VIX futures, VIX ETPs (VXX, TVIX, etc.), VIX options, and SPX options.
Source: Barclays Capital
McMillan’s claim is that volatility ETP providers are causing the term structure of the VIX futures to steepen because they are “forced to sell March and buy April under the terms of the contracts.” That’s what they always do, of course; the catalyst is supposed to be the high volume pouring into products like TVIX, UVXY, VXX, etc.
The concern people have is never precisely specified, and I’m not sure what “things will not end well” is supposed to mean. Index Universe claims you can “front-run” ETP providers in the VIX futures, which is just false if what they’re claiming is that there is a simple, riskless arb here. FT Alphaville floated the idea of position limits. McMillan appears to expect a situation in which the market declines, spot VIX rises, and VIX futures decline in a customer-crushing sort of way. But that’s not possible unless something funny also happens in SPX. Maybe people are connecting up with the widespread concern since 2010 that ETFs – perhaps partly responsible for the May flash crash – will destroy the whole market and that since VIX futures should make you “run away screaming” anyway, ETFs based on VIX futures must be the devil incarnate? I don’t know, and I’m not trying to be flippant. I don’t want to waste time battling straw men, so I’ll just give some reasons why you should believe that nothing unusual is happening.
- We’re talking about pocket change. Even at the peak volume in February, the total vega exposure across all of the exchange-traded volatility products (including VIX options and VIX futures) was just $700m, not an amount that could tank the market. For comparison, notice that vega outstanding over the last year has been around $2B for SPX options alone.
- Customers are long volatility. Long vega exposure in these VIX-based products on the customer side is most likely balanced by short volatility and/or long equity exposure elsewhere in their portfolios. As I mentioned before, this is a feature, not a bug, since well-hedged investors are not as likely to dump stocks if the market turns. If the worry people have is that hedging costs are high now, well, that’s true. But that’s a good reason to pursue a dynamic hedging strategy like VXH, not to warn of some impending market doom.
- And the real clincher: none of this VIX product activity is affecting SPX options. The fact that the dark blue line on the chart above is actually lower now than it was for nearly all of 2011 should tell you that the increased volume in VIX ETPs is not having any adverse effect on the underlying market. For any of these “tail wagging the dog” theories to make sense, you would have to see an abnormal increase in SPX vega outstanding correlated with the rise in VIX futures/ETP vega.
- Bonus: VIX futures are trading in relation to SPX IV right where they normally do. The implied volatility of SPX options as measured using the VIX methodology (link) is running a couple of points lower than comparable VIX futures prices for the same time horizon. For example, September 2012 VIX-style SPX IV is around 23%, while August VIX futures (which will expire to a 30-day VIX estimate) are trading at 26.48. These products are measuring virtually the same thing, so surely that three point premium is evidence of a major market dislocation, right? Actually, no: in last year’s check on IV forecasts for 2011, there was a similar, consistent premium of two points or more between SPX VIX-style IV and VIX futures. That premium held across the term structure for both estimates, and I’ll have an updated 2012-2013 SPX IV roundup for the March issue of Expiring Monthly.
The bottom line is that these ETP issuers are trading in a closed universe: they hedge the exposure generated by increased customer volume, and that hedging activity inevitably appears somewhere. To date, there is no evidence of any unusual vega exposure in SPX options or in SPX forward variance swaps, so the belief that anything is amiss is baseless.