Volatility. Say it with me, Vol-a-til-ity. The word is certainly a trending topic on the Street. However, it’s the lack of volatility that everybody seems fixated on now. Volatility has all but vanished but the amount of products that trade volatility seems to be expanding at an exponential rate. In addition to VIX options and futures, there are now 15 volatility based ETN’s and ETF’s which have a combined $2.3 billion in assets. The biggest and probably the worst performing one is the VXX. This little darling was created by Barclays and was supposed to track short term volatility. Well, it has lost over 90% of its value since inception. Barclays figured it would be approaching zero so a few months back they decided to do a 1 for 4 reverse split to keep milking this cash cow (somebody ought to file a class action on this one). What is really eating away at the VXX is the negative roll yield which Barrons estimates to be around 5%. This is the same reason why the USO does a terrible job of tracking oil. Another problem with VXX is that it tracks short term volatility. And short term volatility has really decided to take a sabbatical. Yesterday, 20-day SPX realized volatility was 6.53%. We are at historical low levels here. You would think that a global economy which is still fragile would warrant a bit more short term volatility than this. So what gives here?
We think a recent note put out by Artemis Capital has the answer: “In theory the Federal Reserve is now the largest volatility trader in the world because current monetary policy is akin to shorting massive amounts of volatility and assuming tail risk. The current regime of monetary and fiscal stimulus is similar to writing a naked put on the entire financial system with margin backed by the US debt. The premium received from the sale of the naked put is financed via demand for our debt and redistributed to the investor class to re-flate underlying asset prices and depress volatility. The theory is that the reinvestment of this premium by investors into underling risk assets ensures the Fed’s naked put is never exercised…..What should be apparent by now is that one day the greatest volatility short in history will face a margin call the US taxpayer will be unwilling or unable to meet.” Here is the full Artemis report, it’s a good read: http://www.zerohedge.com/sites/default/files/ACM_The%20Great%20Vega%20Short.pdf