Shell of Volatility

Pfäffikon SZ, Switzerland – The growth of the financial industry seems unstoppable. The years 2007 and 2008 have painfully exposed what can happen when a large bank gets into trouble. Nearly ten years later, there is not much changed because shell on shell allows for growth in the industry. Investors are moving away from the original blueprint of investing, introduced by the Dutch East India Company in Amsterdam more than 400 years ago.

Change
For decades, investors are told that investing is constantly changing. New products are being launched because it can all be better and cheaper. Again, the past shows time after time that only the original form of investing stand the test of time and that most derivatives disappear from the stage. The shell which is the most on the outside of the original has the greatest risk to be first shelled.

Spread
Many investors have invested in ETFs. It is striking that more and more investors – rightly – are concerned about the underlying value and liquidity of the ETF. Often, liquidity is promised, but in practice, the spread between buy and sell can increase up to 10% and more; cheap is suddenly extremely expensive.

VIX
Notable developments are taking place in ETFs based on the VIX. The VIX measures the volatility in the stock markets; it is a simple calculation based on the underlying index. The value that one attaches to the VIX is, therefore, a sham. When the VIX rises, after all, the damage has already been done. However, option traders make good use of the VIX in their pricing. Options are (too) expensive when you need them.

ETFs based on the VIX has been introduced in the laboratories of the financial industry. This trading around the VIX ––the outer shell–– ensures a pricing of the VIX that develops remarkably, to put it mildly. The trading is, as it were strengthened, and may even provide for a chain reaction. A logical consequence of the popularity of this product is that the trading in volatility has grown tremendously. ETFs can create more shares to meet the demands of short selling. The trading in volatility has undoubtedly affected the equity markets.

The key question is how the inflated trade in these volatility-based ETFs ultimately plays out. Comparisons with 1987 can be made easily. Back then, investors rolled all over each other because of margin requirements and escalated collateralised loans. The same can happen with a VIX which does not behave based on the market, but on the basis of the outer shell which has nothing to do with the original. As a result, at the risk officer, alarm bells that are based on nothing will ring. The suffering is then already suffered.

It remains for me to wish you a good weekend.


Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in above mentioned shares and has no intention of doing so in the next 72 hours.