"Historically there seems to be a new group of people each time that underappreciates the very significant risks of being short volatility and wants to learn this expensive lesson."
Co-inventor of the VIX index, Sandy Rattray is CIO of Man Group, CEO of Man AHL, and a member of the Man Executive Committee, and he has a clear message for investors - he believes it is extremely unlikely that today’s low realized volatility represents a 'new normal'.
In conversation with Goldman Sachs' Allison Nathan in her bi-weekly 'Top Of Mind' letter, Rattray warns "The market is underpricing tail risk today."
Asked about the current popularity of volatility-selling, Rattray responds...
Across many previous cycles, volatility selling tends to be quite popular after long periods of relatively low volatility and unpopular just after volatility has spiked - the reverse of what would seem to be rational.
So the fact that there’s lots of volatility selling at the moment isn’t particularly surprising in my view. Historically there seems to be a new group of people each time that underappreciates the very significant risks of being short volatility and wants to learn this expensive lesson.
In my view, shorting volatility should only comprise a relatively small part of a portfolio, and should have a clear risk-management process around it. If you don’t follow those two rules, then you could potentially end up in significant trouble. There is no question that these short-vol strategies can pose significant risk to individual investors pursuing them if they are not managed appropriately.
That said, I’m not sure these volatility sellers are impacting the market any more than usual. The reality is the low levels of the VIX are fairly consistent with low levels of realized volatility; S&P 500 30-day realized volatility is about 6.6 now, and the VIX is about 10.6, versus a long-term spread between implied and realized volatility of about three to four points. So I don’t think we can blame much on volatility sellers themselves. I see them as playing their traditional role of keeping supply and demand for implied volatility in equilibrium.
And in that context, Rattray has some advice for traders and investors today...
People often ask whether we have a new, lower normal in realized volatility. I believe with some conviction that we don’t. The very low-volatility environment today will end at some point, although it is very hard to forecast why and when that will happen. But we’ve had a fairly strong and continuous rally in equity markets around the world since 2009, and equities in a number of countries, particularly the US, don’t look terribly cheap today in my view. That does not mean that equities are going to correct in the near term. But it is unimaginable that equities don’t correct at some point.
And echoing JPMorgan's Kolanovich...,
The focus is now back on central banks, with the probability of a June 14th hike rising after the FOMC meeting yesterday (probability now at ~80%). A potential risk-off scenario could be a combination of macroeconomic data slowing, but the Fed proceeding with normalization. Neither a modest macro slowdown nor Fed tightening is likely to tip over the market on its own. However, if it happens in the seasonally weak time period, and if it trips up some of the volatility sensitive strategies (e.g., volatility selling, volatility targeting, etc.) the increase of volatility could be more substantial. For these reasons investors should closely monitor incoming macro data
and Paul Tudor Jones...
Just as portfolio insurance caused the 1987 rout, he says, the new danger zone is the half-trillion dollars in risk parity funds. These funds aim to systematically spread risk equally across different asset classes by putting more money in lower volatility securities and less in those whose prices move more dramatically. Because risk-parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline.
“Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”
Indeed, with all that low-vol leveraged, it wouldn't be the first time.
Rattray sees one group in particular as a potential catalyst...
One concern is that many people choose to scale their positions by the level of realized volatility, which means there could be very large positions out there today with potentially significant leverage that might be vulnerable should volatility rise whether due to a tail risk event or other developments in the market.
So it is important that investors have a plan for when the market environment changes. That plan could potentially involve a hedging strategy, a fund-management strategy, or it could come down to asset allocation or rebalancing—though rebalancing, of course, may exacerbate drawdowns. One size does not fit all here, so there is no one clear strategy to pursue.
What is clear, Rattray concludes, is that there will be a sell-off in risk assets at some point, and the investors who are unprepared are those who will potentially fare the worst.