Rate of Change

Every investor and public company experiences volatility – the rate of change in prices.

So every investor and public company should come to the market with a baseline grasp on what others do about the rate of change in prices.

Notwithstanding how Rate of Change would be a good name for a rock band, let’s think about the kinds of money that would be concerned about rate of change, volatility.

Hedge funds. Though as we learned in the hedge-fund panel at NIRI Annual a couple weeks ago (with the help of my good friend Rich Barry, I assembled the group on the stage), hedge funds may have longer horizons than you think.

One of those folks said, however, putting emphasis on rate of change, “Whatever assets we’ve got under management, put a multiplier of 5-8 times on it, because that’s our economic impact on markets.”

You’ve got pension funds, commodity funds, insurance companies.  All are impacted by the rate of change in prices.

There are Fast Traders – machines in the markets driving about 45% of trading volume in US stocks that continuously calculate recovering and deteriorating prices. They’ll want to extend their influence in a way that profits from these rates of change.

Am I going somewhere with this?  Yes. And it’s happening right now. Stay with me.

Mutual funds too, especially indexers.  Index funds are the biggest consumer of options and futures because they track the mean, a benchmark. Volatility causes tracking errors.

They can adjust for index errors by buying or selling options (or futures, or repurchase agreements, or forwards, and so on). Most prospectuses include provisos for using about 10% of funds toward these ends.

Only one asset class, however, owes its existence to the rate of change: Exchange Traded Funds. They’re the only financial instrument ever created that was imbued with special regulatory dispensation to pursue arbitrage.  Which is…anyone?  Anyone?

Profiting on the rate of change in prices.

Arbitrage cannot exist if prices don’t change. There was almost no currency arbitrage before the USA left the gold standard in 1971. Exchange rates were fixed. Today, there are $544 TRILLION of over-the-counter derivatives swaps, most tied to currencies and interest rates designed to compensate for continual rates of change.

You know the VIX, the fear gauge?  Instruments tied to it expire today. It’s a way to profit on the rate of change.

Heard of the VVIX?  It tracks the annualized presence of volatility. It was created in 2006 and closed that year over 71%. It’s never been sustainably lower. It’s currently at 96%, about where it was in December last year.

Volatility is rising, not muted as the VIX suggests. Why? Blame can be spread around but it concentrates in ETFs. ETFs aren’t compensating for it. They’re depending on it.

ETF volatility – we track it – averaged 11% PER WEEK between Dec 14, 2018-Jun 14, 2019. Annualized, that’s nearly 600%. In fact, volatility between ETFs and the underlying stocks they’re supposed to track was 23% in April 2019 but a staggering 481% in May when stocks were down for six straight weeks. It suggests low spreads (April) triggered weak markets (May).

Maybe the Dow Jones would be at 50,000 if so many didn’t feed on the rate of change.

Is it good for investors and companies that the focus of the stock market has shifted from what rises or falls to what the gaps are between those items?

We get to today. Options expire today through Friday. These instruments tie to the rate of change in prices.  S&P indices, the benchmarks, true up quarterly this week. Russell indices are in phase three, the penultimate, of annual reconstitution, and they depend on the absence of a rate of change.

New options trade Monday, Jun 24. Counterparties will true up exposure Tuesday the 25th. We’ll see reality around Jun 26-27.

The bigger the money tracking a benchmark, the bigger the assets pegged to ETFs, the more consequential the rate of change of prices becomes.

And it warps any interpretation of fundamentals.

We cannot suppose that fundamentals price stocks when 100% of NET new inflows to stocks the entire past decade have gone to instruments attempting to mitigate the rate of change by tracking some measure.

I hope I’ve made the point.

The data tell us the rate of change could take a stomach-jerking step. Why? Too much money depends on preventing it or fostering it. Tug of war.  It may not happen. But be ready.