Dubious Distinction

“As the world’s largest and deepest equity market, the U.S. tends to be the relatively steady hand among volatile peers.  Not anymore.” (Lee, Bloomberg, January 7, 2019)

This was the opening comment in a recent Bloomberg article about increased volatility in U.S. markets. Morning Brew (Freyman, January 6, 2019) provided additional perspective, noting that the VIX Index (aka Wall Street’s fear index) had the dubious distinction of outpacing the corresponding measures in Europe, Hong Kong and emerging markets in December. vix historyYes, volatility in the U.S. was higher in 2018 than in the recent past, but for perspective, its still largely below the levels experienced during the financial crisis and roughly on-par with the levels during the dot-com bubble at the turn of the century.

Still, volatility being up sounds worrisome.  But what does this really mean?  Let’s breakdown the components used to arrive at the VIX Index:

  • The S&P 500 Index is a market-capitalization weighted average of the 500 largest public companies in the U.S. As such, the S&P 500 Index is a calculated value, existing only on paper, although you can buy mutual funds and ETFs designed to replicate the index. The S&P 500 Index is considered a benchmark for the overall economy and equity portfolio performance.
  • This is where S&P 500 Index (SPX) future options come in. Investment managers use SPX futures as a form of insurance – to hedge portfolio performance in changing market conditions.  Others simply want to predict (speculate on) the future level of the S&P 500 Index.  There are a series of weekly and monthly expiration dates on SPX futures which can extend well into the future. Just like buying insurance, the SPX trades and settles using cash – something to think about given the extent to which index futures are traded on margin.
  • The VIX Index uses SPX future options as a means to predict the volatility in the S&P 500 Index over the next 30 days. The VIX is calculated using the midpoint of the bid/ask quote on a constantly changing portfolio of SPX future options that have expiration dates more than 23 days but less than 37 days away.  Like the S&P 500 Index, the VIX is a calculated value, existing only on paper

So, let’s follow the logic chain:  We start with a weighted-average based on the real market value of the 500 largest companies in the U.S.  Because there’s a desire to hedge, predict or speculate on this benchmark’s outlook, futures options are available to do that.  But, every minute of every day there are different views of where the benchmark is headed and to measure this variation a weighted-average based on said futures options is used.  This sounds logical when you read it forward, but can you read it backwards: Can changes in the VIX drive or influence changes in SPX trading and in turn effect the value of companies in the S&P 500?  Can the tail wag the dog?

Today, more than a third of all assets under management is passively managed (i.e., in index funds or ETFs), a big chunk of which use algorithms tied to the S&P 500 Index to inform its trading strategies.  So, while the financial markets are considered efficient and rational, it’s hard not to worry about getting caught in a feedback loop.

For example, there are future options on ETFs like the SPDR S&P500 Trust ETF (SPY). Could an anomaly with a well-known ETF like this spread to the VIX or other similar instruments?  Many believe it’s unlikely and note that estimated total assets invested in individual index futures like this is tiny (in the billions of dollars) compared the total S&P 500 market capitalization of $21 trillion, so any impact should be contained. That’s good news, but a dubious comfort.

Lisa Ciota
Lead-IR Advisors, Inc.

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