Exchange-traded products allowing investors to bet that volatility would remain low exacerbated February's sharp falls in equities, the Bank for International Settlements said in its quarterly review, in which it called for further study of the ways passive funds tracking indices and asset prices can cause price feedback loops and destabilize markets.
The widely watched VIX measure of volatility jumped by 20 points on Feb. 5, its biggest daily increase since the 1987 market crash and a significantly greater rise than expected given the 4% decline in the S&P 500 stocks index that day, the BIS said. The VIX spiked after other market participants, aware that passive funds tracking the gauge had to rebalance their derivatives portfolios by 4:15 p.m. every trading day, began bidding up VIX futures at about 3:30 p.m., and the subsequent squeeze in volatility magnified equity market declines.
"Overall, market developments on 5 February were another illustration of how synthetic leveraged structures can create and amplify market jumps, even if the core players themselves are relatively small. For investors, this was also a stark reminder of the outsize risks involved in speculative strategies using complex derivatives," the BIS said. The reported noted that one exchange-traded product allowing investors to bet that the VIX would remain low was terminated after it fell by 84% Feb. 5.
Years of rising stock prices, supported by historically easy monetary policy, prompted large numbers of investors to turn to exchange-traded products offering short-VIX or leveraged returns, as a means of betting that volatility would stay dormant. This strategy had long been profitable, but one whose risks were exposed in February, the BIS said.
"Although marketed as short-term hedging products to investors, many market participants use these products to make long-term bets on volatility remaining low or becoming lower. Given the historical tendency of volatility increases to be rather sharp, such strategies can amount to collecting pennies in front of a steamroller," the BIS said.
One transmission channel from the soaring VIX into declining stocks opened as VIX futures dealers hedged their exposure to exchange-traded products by shorting S&P 500 futures, putting more downward pressure on equities, the BIS said. Algorithmic trading seeking to arbitrage disparities between exchange-traded funds, futures and cash markets also kept prices moving together.
The BIS called for more examination of the way that trading in passive funds in general can feed into prices for stocks and bonds. The popularity of passive funds, which attempt to reproduce the movements of indices of stocks or bonds, has grown sharply, reaching $8 trillion or 20% of aggregate investment fund assets as of June 2017, up from 8% a decade earlier. Passive funds now represent 43% of total US equity fund assets, worth $4 trillion.
Investors have opted for passive funds on the assumption that active investors seldom beat overall market performance. But, the BIS pointed out, the greater the proportion of securities held passively, the less market prices are determined by analysis of the fundamental value of the assets traded. Passive funds might also increase the tendency of stocks or bonds to rise or fall simultaneously. While index-tracking mutual funds seem to have exerted a stabilizing influence in recent bouts of volatility, and didn't see big fund outflows, attempts by active investors to arbitrage differences in price between exchange-traded funds and their underlying securities may have had the opposite effect.
"The link between ETF trading and underlying security prices deserves further study. In particular, secondary market arbitrage of ETF shares appears to constitute an additional (and potentially more important) transmission channel to prices compared with that which works through fund flows," it said.
