Last week, we wrote a post discussing the volatility environment we’ve had over the last 8 years and how that’s impacted ETF flows. You can read it HERE.
What’s causing this and who is benefiting? First for the cause:
We had a debt problem. That led to a crisis. The Fed stepped in, lowered rates and began gobbling up debt. Most are familiar with QE and the debates over QE’s effectiveness. We have no desire to join in on that argument, but we do believe that monetary policies have dampened volatility. As Alberto Gallo wrote in his article yesterday, read it HERE, – “Central bank purchases of government paper reduce yields and volatility. In turn, this pushes investors to search for yield in other markets, such as investment-grade and high-yield bonds. This search for yield lowers funding costs for firms, but also risk premia associated with default risk and credit volatility. The next step for investors is to turn to other means to achieve yield, selling volatility for example.”
QE and loose monetary policy has investors reaching for yield. What’s even worse, it’s given the illusion of strategies that short volatility being a safe-haven for a few extra basis points of yield. In fact, this headline is what triggered this follow up post, “One of the market’s hottest trades just had its biggest day yet”
Here is the start of the article, “An exchange-traded note betting that US stocks will essentially sit still for the next month saw record trading volume of $3.3 billion on Thursday, June 22, according to according to Macro Risk Advisors (MRA), a firm that arranges volatility trades.”
There’s a place for shorting volatility, especially for well-informed, risk-seeking investors, but I have to wonder; Is 3.3bil in a day to an ETN that’s short volatility the product of only well-informed, risk-seeking investors? That’s what I don’t know. I don’t know how many advisors and individual investors have bought into the idea that shorting volatility (especially naked options) is a yield enhancing, risk free endeavor. I hope not many, but my hope is probably wrong.
What happens when the biggest contributors to this low volatility phenomenon change their actions? We may just find out, as central banks around the world are doing more than just hinting at tightening. My guess is the laws of financial markets have not fundamentally altered – volatility still exists. As attractive as short volatility strategies have been recently, investors should always remember, past performance is no guarantee of future results.
***I’ve been asked to explain the naked options comment. Let me explain in terms of naked put selling. Selling a put option is a form of shorting volatility. No volatility – you keep the premium. The flip side is ugly. It’s the equivalent of picking up a nickle off a train track each day. You could be successful in your nickel pick up strategy every single day for a long time. All it takes is one mistake and all that success is pointless. The article was written to point out how monetary policy is contributing to the illusion that the tracks have no trains, and the nickel is free money. Make no mistake, there are trains on the track. The moral of the story is this, if you’re not a well informed investor seeking risk – don’t sell naked puts.