April 21, 2021

Swapping Volatility

Google chose as motto “don’t be evil.” “Beware derivatives” isn’t a bad motto either.

If you’ve read the MSM long, you know we’ve beaten the drum like Boneshaker (when you hear the sound of the drum, here we come) over the risk in derivatives.

Oh please, Quast.  Can’t we talk about something more interesting, like the molecular structure of Molybdenum?

Do you want to know what’s coming, public companies and investors?  We’ve now been warned twice.  I’ll explain.

Before that, this: Recall that we said the market could take a beating this week because of derivatives. A raft of major banks have reported combined damage in the billions from bad derivatives bets by one hedge fund, Archegos Capital.

And VIX bets hit today.  Volatility bets blew up another fund.  Warning Signal No. 2.

Gunjan Banerji wrote about it yesterday in the WSJ (subscription required), admirably explicating the complexities of variance swaps.  The Infinity Q Diversified Alpha Fund shut down.

Diversified Alpha, a mutual fund marketed as a hedge fund for the masses, had roughly $1.75 billion of assets at last word.  The fund aimed in part at volatility strategies.  It said:

“The Volatility Strategy seeks to profit from the mispricing of volatility related instruments across equities, currencies, bonds, interest rates, and commodities markets. These instruments include options, variance swaps, correlation swaps, and total return swaps. The Strategy invests across a wide range of time horizons and takes long and short positions in the underlying volatility instruments.”

The fund went broke betting on volatility – mispricings.  That’s two in short succession.  Diversified Alpha filed its plea with the SEC Feb 21 to halt redemptions. Right after February expirations. Archegos Capital went belly-up with March expirations.

Much of the money in equities trades mispricings. That’s what ETFs do (ETF vs a basket). It’s what Fast Traders do (one price vs another). It’s what derivatives traders do (stocks vs options).  Those behaviors are roughly 80% of US equity volume.

These disasters you describe, Tim, are isolated to leveraged outfits.

Nope.

Here’s the SAI for the Blackrock Technology Opportunities Fund. I have read a great many SAIs, a reason I’ve in the past highlighted risks, especially for Exchange Traded Funds.

On page 3 is this: Only information that is clearly identified as applicable to the Fund is considered to form a part of the Fund’s SAI.

Then follows a table, with X’s by what applies.  See page 4, the derivatives section. Derivatives for hedges and speculation apply.  Credit default swaps, interest-rate swaps, total return swaps, options on swaps, on it goes.

I’m sure it’s a small part of this fund’s assets, used within rules to true up tracking or remediate some of the unremitting volatility that’s been seeded in all financial instruments by vast artificial quantities of money and low interest rates. But read the SAI on your favorite fund. What’s it say?

By the way, volatility in stocks has plunged by 50% the past couple weeks. Almost like a tide going out ahead of a tsunami. Behind it in other data we track are vast swings in standard deviation between the prices of sector stocks and the ETFs tracking them.

That is, if we compile moves of all sector stocks and the average is a 1.8% decline and the composite average for sector ETFs is 0.1%, standard deviation is 625%.

It suggests to me that ETFs are substituting stuff that moves less than stocks – like swaps or IOUs of some sort, or cash – to get away from the error-inducing volatility in stocks.

But that could blow up derivatives predicated on a statistical equity basket. What the hell is going on?  Exactly.  That’s what I want to know. Something is wrong, and we’re seeing little fissures, seeping steam, wisps of ash.

We’ve long been concerned about these risks. But they’re like the way Ernest Hemingway described how one goes broke (a line I’ve used often): very slowly then all at once.

I’m not wringing my hands. Forewarned is forearmed. Investors and traders, it’s wise to get out of the pool around these things, which we observe in the data, and report.

And for public companies, it’s high time to make sure your executive teams realize risk resides beyond “alternative investments.” It’s everywhere. All around us. 

How central are Morgan Stanley, JP Morgan, Credit Suisse, Deutsche Bank, banks losing on Archegos, to financial markets from IPOs to Treasury Open Market operations?  Derivatives to equity and ETF trading?

It may be the cost of paying ourselves to sit out a Pandemic is the stability of our financial markets. We’re inflating everything including derivatives.  We can survive it.  In fact, it would do us good to roll around in the dirt and develop some resilience.

Whatever happens, we’ve got the data.  We warned EDGE users to be out by last Friday. We can tell you, public companies, if these instruments are large in your price. 

Everybody is swapping volatility. Beware.

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