Despite the rise in market volatility in Asia and other markets, the use of volatility index (Vix) futures has yet to attract much investment from regional institutional investors.
Many of the asset owners blame the fact the derivatives trade in a complex manner and rely heavily on market speculation, while noting that there are cheaper and simpler ways to hedge against market movements.
Erik Norland, London-based executive director and senior economist at CME Group, told AsianInvestor that Vix futures usually have a negative carry, meaning the cost of holding a security exceeds the income earned. This is because the forward curve for Vix futures is usually in contango, where an asset’s forward price is higher than its spot price.
When a market is in contango, the forward price usually drops to meet the future spot price as they draw closer. That drop in price can be costly to investors that hold net long forwards positions.
Of course, investors holding Vix futures can make money when equity market volatility spikes. But the instruments typically lose money during calm markets, which prevailed for several years before 2018. In addition, the derivatives have a limited shelf life, and investors need to renew them (known as rolling them forward) once they expire, which also has a cost attached. In essence, investors who are long Vix futures keep bleeding money until the market experiences a major market collapse.
Of late Vix futures have been in the opposite position to contango, known as backwardation, as investors have bid up the price of shorter-term forward contracts in the expectation of more volatility to come.
There have been only two other periods since the inception of Vix futures in 2004 where the curve was in backwardation: during the global financial crisis of 2008, and when the US lost its AAA credit rating from Standard & Poor’s in 2011.
However, that isn’t proving tempting Asian institutional investors into such products. “Backwardation won’t raise my interest in volatility products, because its pattern changes too fast,” said the unnamed executive of the international insurer. “From contango to backwardation, the pattern itself is very volatile. The volatility of volatility products is very high.”
Investors are also reluctant to use Vix products to hedging volatility, in large part because there are simpler ways to do it.
“I won’t look at volatility products. Insurers can use the most direct way. If I want to hedge against [falling] equity positions, I can buy out-of-the-money put options,” said the unnamed insurance executive. Such a put option has a strike price that is lower than the market price of the underlying asset.
“We have bought things like Vix futures for the purpose of hedging against risk. But its portion in our portfolio is miniscule… like next to zero,” said Sophia Cheng, chief investment officer of Cathay Financial.
“Such derivative-related assets account for only a small portion of our portfolio because we have a risk allocation discipline,” she told AsianInvestor.
BLF invited bids for a $2.8 billion global absolute-return equity mandate late last year, which targets a return of US dollar three-month Libor plus 5%. The five external managers who were awarded the mandate early this year were allowed to use total return swaps (TRS) in the mandate. It was the first time BLF had permitted the use of this derivative tool.
Fund managers can use the swap to increase or decrease exposure to a stock or stock index without changing their asset allocations. They can enter into a swap with a dealer to pay the return of index A and in return receive the return of index B over a specified period of time, if they have an bearish view of the former or favourable view of the latter for the horizon.
RETICENCE TO STAY
While institutional investors are proving ambivalent about Vix products to capitalise on volatility, there are other means of benefiting from volatility spikes. Norland of CME Group said one way is to long US Treasury futures because these often–although not always–rally when equity markets sell off.
Asked about the edge of Vix products over other instruments, Cboe said it generally believes that the derivatives are best used as part of an overall equity investment and hedging portfolio.
Despite the reticence of regional investors, Cboe is making an effort to gain their interest. Michael Mollet, Chicago-based director of product development at Cboe Global Markets, said his organisation had focused its investor education efforts in the US and European markets, but it has more recently focused on Asia, holding conferences to educate investors on volatility and derivative products.
So far however, there haven’t been many bites. “There has been higher interest in volatility trading among institutional investors and they are more willing to consider them, but not a lot of them are implementing them,” said Janet Li, wealth business leader for Asia at Mercer.
The world’s equity markets may be getting prone to abrupt changes in altitude, but Asia’s investors remain leery of the complex tools that track these shifts. Investing in volatility isn’t the most stable of activities, after all.
Please click here to read the first part of this feature, which was adapted from our April/May magazine.