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Wall Street's Intriguing Gamble on AI-Era Stability Spurs ETF Growth


Leo Gonzalez

March 10, 2024 - 20:18 pm


Wall Street's Alluring Bet: Riding the Calm Amid AI Boom

As the artificial intelligence (AI) boom propels prominent companies like Nvidia Corp. to new heights, a subtler yet substantial movement is taking root at the core of the U.S. market. This movement centers on investors channeling massive funds into strategies that rely on the continued stability of equity markets.

The Resurgence of Short-Volatility Bets

Only a few years after the debacle of early 2018, which saw the dramatic collapse of similar gambles, short-volatility bets are re-emerging, albeit in a distinctive form. Currently, these bets predominantly manifest as Exchange-Traded Funds (ETFs) that engage in selling options on stocks or indexes, aiming to bolster returns through these transactions. Astonishingly, assets within such products have nearly quadrupled over the span of two years, amassing a record-breaking $64 billion according to the data from Global X ETFs. In contrast, their predecessors, a small ensemble of funds that made direct wagers on volatility expectations, held a mere $2.1 billion prior to their implosion in 2018.

The Allure and Risks of Betting on Market Tranquility

Shorting volatility is an investment technique that can generate impressively consistent profits, assuming that the market remains pacific. However, concerns are rising as this approach amasses assets and faces significant risks, including events like the U.S. presidential election. Chris Murphy, co-head of derivatives strategy at Susquehanna International Group, voices the anxiety prevalent among clients concerning the impact of this strategy on the markets and the cyclical nature of the short volatility trade that tends to end abruptly in the wake of major shocks.

A Shakeup in Strategy Structure

The good news for those alarmed by the rise in these bets is that today's funds differ structurally. The current income ETFs employ options on top of a long stock position, diluting the portion that's wagering against market fluctuations. Consequently, there's a more substantial threshold against widespread contagion compared to the market status six years ago, which has since doubled in size.

Conversely, the negative aspect lies within the observed suppression of stock volatility by these positions. There's growing suspicion that this could foster a cyclical loop of increased bets for calm, which might eventually reverse with unforeseen consequences. Furthermore, these strategies fall within a broader—and explosive—growth of derivatives trading, which casts a new layer of unpredictability onto market dynamics.

The Derivatives Boom and Its Consequences

Last year witnessed a surge in U.S. equity options trading volume, breaking previous records. This increase is partly driven by the explosion in trade involving zero-day expiration contracts, also known as 0DTE. This growth, in turn, expands the volatility market, with each derivative representing a wager on future market activity.

"Given the enhanced speculative demand for options, particularly the short-dated kinds that resemble lottery tickets, there must be a seller for those," explains Vineer Bhansali, the founder of hedge fund LongTail Alpha LLC. This is where many income ETFs step in, capitalizing on demand by selling options to generate additional returns on underlying equity portfolios, with the hopes that these contracts expire valueless for a tidy profit.

The Remarkable Growth in ETFs

The expansion in recent years within the derivative income funds sector is indeed staggering. Data compiled by Morningstar Direct indicates that at the end of 2019, this category held approximately $7 billion in assets, with mutual funds constituting three-quarters of that sum. By the end of the following year, it soared to $75 billion, with ETFs representing nearly 83% of that total.

Despite the heightened level of involvement, derivatives specialists remain cautious. They have not yet rung the alarm bells for a possible "Volmageddon," reminisce of the 2018 sell-off event. John Marshall, head of derivatives research at Goldman Sachs Group Inc., suggests that the strategies predominantly encounter stress when the market experiences a sharp uptick, as this increases the chances of call options being exercised, potentially obligating the seller to supply the underlying asset at a rate below the current price.

The Hidden Side of Wall Street's Latest Obsession

Uncovering every facet to gauge the extent of the short-volatility trade is challenging. Beyond the surface-level income funds, myriad complex strategies linger, particularly on trading desks with inaccessible public information. Steve Richey, a portfolio manager at volatility hedge fund QVR Advisors, points out that for every visible trade, there may be up to tenfold unfolding out of sight, fueling speculation about larger undercurrents.

Unseen Bets and Quantitative Strategies

The shadowy portion of the market includes substantial segments of quantitative investment strategies (QIS) resembling and often directly involving structured products peddled by banks. According to PremiaLab, QIS offerings across 18 banks returned 8.9% in the U.S. last year, constituting around 28% of the newly added strategies on their platform over the preceding 12 months. While the actual size is unknown, consultancy Albourne Partners estimated last year that QIS trades overall oversee roughly $370 billion.

In another facet of the volatility market known as the dispersion trade, hedge funds place wagers on the volatility of an array of individual stocks while simultaneously betting against the fluctuation of an index like the S&P 500. The strategy can prosper under market conditions featuring lower overall volatility or less turbulence than the constituent shares. Cboe Global Markets acknowledges the strategy's popularity, with plans to introduce a futures product linked to the Cboe S&P 500 Dispersion Index within the year.

Kevin Muir, the voice behind the MacroTourist blog, warns that this burgeoning strategy's opaque nature and use of leverage might precipitate a crisis should the market take a downturn, triggering severe position unwinding.

Vega: Wall Street's Volatility Barometer

Estimations of market risk often entail calculating 'vega,' a metric reflecting an option's volatility sensitivity. A measure developed by Ambrus Group aggregates vega from pivotal arenas: the S&P 500 Index, the VIX, and the SPDR S&P 500 ETF Trust (SPY). Comparing present conditions, Kris Sidial, co-CIO of Ambrus, noted that net short vega exposure is now twice the size of what it was before the 2018 turmoil.

Eerie Calm on The VIX Amid Geopolitical Strife and Monetary Tightening

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The Bank for International Settlements' latest review suggests that the recent unprecedented low levels of the VIX despite major geopolitical conflicts and the Fed's pronounced monetary measures points to the expansion of vol-selling strategies. The review posits that the burgeoning of yield-driven structural products tied to the S&P 500 is in tandem with the suppression of VIX levels over a similar timeframe.

Despite fundamentally sound reasons for volatility suppression, such as a steadily ascending stock market and a non-shock-inducing economy, the persistent calm raises eyebrows. The suggestion is that the throng of income-generating contracts might be capping implied volatility. True Partner Capital's Toby Hekster warns that the lengthier market tranquility, the harsher the potential recoil should volatility be disrupted.

The Perils within the Passive Market Landscape

A myriad of macroeconomic factors, from wars to inflation and elections, could potentially disrupt the market's steady climb. While profitable in times of low volatility, these strategies have also historically compounded downturns. Notably, the VelocityShares Daily Inverse VIX Short-Term note (XIV) saw its assets dwindle dramatically, from billions to millions, within a day during the February 2018 sell-off event.

Conclusion: Treading with Caution into the Future

To date, no catalyst has emerged to occasion a repeat of the 2018 incident. Instances such as the Israel-Hamas conflict or unexpected inflation surges in the U.S. have not perturbed the serenity of the market, with the VIX remaining under its historical average for an extended period. Nevertheless, Hekster maintains a cautious stance: the absence of risk materialization does not imply nonexistence. Should the market trip, the suppressed volatility could unleash with surprising intensity.

The nuances of Wall Street's betting scene remain as intricate as ever. With unwavering interest in AI and companies reaching unparalleled valuations on one side, and the quiet yet powerful shift towards strategies banking on market steadiness on the other, the financial world continues to ebb and flow with every passing event. The prevailing calm betrays not a complete absence of risk, but rather a latent force that could reshape fortunes at the slightest upheaval.

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