One of the most important questions for markets going forward is whether the presence of systematic strats and the proliferation of VIX ETPs will ultimately conspire to create what we’ve variously described as “the doom loop.”
We’ve written copious amounts of posts about this dynamic which you can peruse at your leisure here.
When stripped of the technicalities, the premise is pretty simple as these things go. Levered and inverse VIX ETPs would be forced to rebalance on a nominally small vol. spike and to the extent that rebalance exacerbates said spike, vol. control funds, CTAs, and risk parity could be forced to deleverage into a falling market.
This has become one of the rallying cries of the “Chicken Little” contingent and it’s a topic that JPMorgan’s “Gandalf” (Marko Kolanovic) has been keen on warning about for quite some time. The quant crowd isn’t fond of the notion that they’ll be an aggravating factor in the next plunge and the VIX ETP crowd doesn’t generally understand the role they’re playing in what amounts to a buildup of systemic risk.
There are plenty of people who will tell you why none of what I’ve just said is possible and indeed, there are some folks who will claim it doesn’t make much sense at all, but I would submit that those rebuttals will one day be looked back on as something akin to “famous last words.” So you know: “time stamp it.”
Well in a sweeping new note out Tuesday, Goldman takes a look at this dynamic asking “would automatic flows exacerbate a potential selloff?”
“In moments of stress, products that de-risk when risk rises (including volatility control strategies and trend-following strategies) can create feedback loops,” the bank notes, echoing our “doom loop” characterization. Here’s some further color:
Volatility control strategies typically sell equities when vol rises above a threshold, but with vol well below-target a prolonged pickup in vol would likely be needed. The S&P 500 Managed Risk – Moderate Index, which consistently would have had 7-10% 12-month rolling realized vol in its history, has now had 5% realized vol over the past 12 months. A quick selloff would drive this index and the large funds that have similar strategies to start realizing near-target vol, rather than above-target, so we would not expect them to de-risk in an initial pickup in vol.
Growth in levered, short VIX ETPs has increased their potential feedback loop impact. Over the past few months, the combination of product inflows (to long VIX ETPs, as a hedge), strong performance (of short ETPs, following +135% YTD performance), and low VIX futures prices (allowing more futures to “fit” inside each ETP share) have brought the gross VIX ETP market size to a new high (the net size with offsetting long and short products is less long than usual).
