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Volatility Controlled Funds

Equity volatility metrics across the board have compressed significantly post “banking crisis”, VOLI which is a measure of ATM volatility is trading at levels we have not closed at since April last year. VIX (S&P), VXN (Nasdaq) and V2X (Euro 50) all at lowest levels "since forever" (chart below).

The VIX ended last week at 17.07, its lowest close in 15 months and near the historical low of 16. 1 Month IV also at lows sub 15% which is associated with reduced equity vanna tailwinds. Meaning, any further volatility compression will have little to no impact on equity prices, it further implies that longer dated IV may be reasonably priced.

Why is the VIX so low?

There are a few reasons why volatility has contracted this much despite ongoing stresses in the banking system,

1.) Low leverage: When participants are positioned lightly to the upside then they have little need for long put protection. This lack of demand lowers the VIX. One of the major reasons why positioning is so low is because the cost of margin is very high compared to where it was a couple years ago.

2.) Covered short put strategies: this has been a favorite among participants over the past 12 months. This is a defined-risk strategy where traders short the underlying security and also short puts; it is the opposite of a covered call. Short puts are a volatility killer.

3.) Neutral positioning: Structurally we are in a tight range and in a mostly neutral market gamma environment, as realized volatility declines so does implied volatility.

Volatility Controlled Funds

In our April 13 Market Report we highlighted the mechanical flows that have been playing a key role in supporting the market.

● Volatility control funds are buying into equities as realized volatility(RV) is collapsing

● Option dealers continue to buy dips above the FLIP

● CTAs (systematic strategies) are still buyers according to Goldman Sachs Since we are on the topic of volatility we will highlight the significance of volatility controlled funds at this juncture.

Volatility controlled funds (such as pensions and annuities) base their exposure on realized volatility(RV). When the level of volatility is declining/low, a volatility controlled fund may increase its exposure to riskier assets, such as equities or high-yield bonds. This is because there is a lower likelihood of significant price swings, and the potential for higher returns may outweigh the potential for losses.

On the other hand, when the level of volatility is rising/high, the fund may reduce its exposure to riskier assets and increase its exposure to more stable assets, such as cash, government bonds, or low-volatility stocks. This is because the potential for significant losses during times of high volatility may outweigh the potential for higher returns.

Since volatility has contracted significantly over the past weeks, volatility controlled funds have increased exposure to equities and have supported the “buy the dip” trade. With realized volatility now near long term lows it is mostly restricted to moving up from here (especially short term RV) this creates a bearish headwind for the market. This is because many of these volatility controlled funds would be selling as RV moves higher, even if that RV expansion is a result of an upside rally.


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