In the days leading up to the extraordinarily contentious U.S. presidential election, the CBOE Volatility Index commonly referred to as the VIX reached its highest levels since early summer, when markets trembled during the run-up to the June Brexit referendum in the U.K. After an election cycle that has proven to be wildly unpredictable, managers of volatility-focused funds in the U.S. now face an outcome with the potential to cause major swings in their portfolio values.
The VIX, sometimes referred to as the U.S. stock markets fear index, is a measure of the cost of purchasing options on the Standard & Poors 500-stock index. During periods of extraordinary volatility, the cost of options, swaps, and other derivatives tends to increase sharply as investors hedge risks and speculators wager on whether the chaos will pass quickly. In the world of alternative investments, managers solely focused on capturing returns based on changes in these markets are often the first to feel the impact of surprise events. Futures on the VIX, traded on the Chicago Board Options Exchange, allow investors to place a bet based on their expectations for how volatile options markets will be in the future.
The worlds investors have kept a close eye on the 2016 U.S. presidential election, a race many political analysts agree is perhaps the most bizarre in living memory. From the highly controversial, populist political rhetoric from GOP candidate and real estate mogul Donald Trump to the law enforcement scrutiny surrounding Democratic candidate Hillary Clinton over her use of a private email server during her tenure as secretary of State, the contest has been full of surprises that have affected market sentiment.
Some market analysts have noted that large investors have been remarkably pessimistic, despite a strong recovery from the stock markets lows in February of this year. In a note to investors, New Albion Partners chief market strategist Brian Reynolds observed that the pullback in equities last week marked the 21st such move over the past six years, a period marked by an inversion of the VIX futures curve. (Since traders use VIX futures to profit from future volatility levels, a shift in the curve suggests the consensus risk forecast has shifted.) Reynolds suggested that investors have overreacted.
We remain in one of the greatest bull markets of all time, yet equity investors keep repeating the insanity of looking for a financial market collapse, as the flow of pension money resurrects the bull market time and again, like playing a song on repeat over and over, he wrote.
Not everyone agrees that this increased caution is a signal that investors have become overly bearish, however.
The election doesnt matter, says Mark Spitznagel, founder and chief investment officer of Miami-based Universa Investments. Ultimately, the markets are where they are thanks to the unprecedented hubris of central bank intervention, and neither candidate can stop the carnage that will follow. Spitznagel argues that this election is a case of be careful what you wish for, adding, The winner will inherit an economy and markets that are poised to crash.
Universa, which focuses on trading strategies designed to profit from market shocks and is best known as a tail-risk manager, was widely reported to have realized a one-day return of more than 20 percent during the U.S. equity market swoon in late August of last year. Spitznagel and his colleagues present the firms strategy as an allocation vehicle for institutions wishing to manage market volatility driven by outlier events.
Many portfolio managers pursuing derivatives strategies appear confident that the market follow-through on the vote outcome will be less intense than some measures of volatility currently indicate. These speculators, banking on the mean reversion commonly associated with volatility, are expecting the dust to settle sooner rather than later.
Aaron Wallace, founder of Los Angelesbased startup Carbide Capital, likens the U.S. presidential race to the Brexit vote in terms of potential market impact and is not anticipating a prolonged period of heightened volatility in derivatives markets.
Regardless of the outcome, eventually cooler heads will prevail, and the VIX will trade lower even if there is an initial spike, he says. Market action seems to indicate that a lot of investors have already hedged, so I just dont see that much more potential for an upside in volatility, even with a surprise outcome.
Either way, investors can play the chaos to their benefit. The array of vehicles designed to profit from volatility has never been more diverse, according to Thomas Lee, managing director of investment strategy and research at Parametric Portfolio Associates, a subsidiary of asset manager Eaton Vance that manages volatility strategies and oversees more than $170 billion in assets.
Volatility is becoming more of a mainstream asset class, says Lee, who adds that the ever-increasing desire for diversification among institutional managers is more than understandable.
Equity risk tends to be highly concentrated within institutional portfolios, he says. Correlations with equities tend to rise during the worst possible time.