In this Oct. 2, 2014 file photo, people pass a Wall Street subway stop, in New York's Financial District.Richard Drew/The Associated Press
Some of the most popular securities in the equity market have been at the centre of some of its most misguided trades.
Consider the last six weeks, when investors poured a record $2-billion into exchange-traded notes that track volatility in the Standard & Poor's 500 Index. The securities, which are bought and sold like stock and appreciate when turbulence rises in the market, lost half their value during the stretch as a rebound in U.S. equities added more than $1.5-trillion to share prices.
The securities, with daily volume that is usually twice that of Apple Inc. or Microsoft Corp., have repeatedly proven a graveyard for bears -- though rarely to the extent they did in March. It's a testament to the hazards of market timing and shows how violently the resilience of American equities has blindsided the most sophisticated traders over the last two years.
"The market has a way of humiliating as many people as it can," said Steve Sosnick, an equity risk manager at Timber Hill, the market-making unit of Greenwich, Conn.-based Interactive Brokers Group Inc. "Consensus trades like this, especially when they're contrarian, often don't pan out."
Trading in the notes has exploded as the bull market plodded on. The biggest, iPath's S&P 500 VIX Short-Term Futures ETN, has seen average daily volume of more than 80 million shares in 2016, up from 57 million last year. In 2011, two years after the note was launched, average volume was less than 2 million shares a day.
To be sure, not everyone buying the notes is taking a directional view on equities. The ETNs are used by high-frequency traders to balance their holdings and by bullish investors trying to hedge against losses. But the propensity over the last six years for demand to surge just before the VIX tumbled is uncanny.
Among the country's most heavily traded stocks, volatility notes are issued by banks and use a hodgepodge of derivatives and futures to track the ups and downs in the Chicago Board Options Exchange Volatility Index. Owning one amounts to a bet that stocks will fall since the VIX moves in the opposite direction of equities about 80 per cent of the time. VIX futures expiring this month slipped at 6:26 a.m. in New York.
Unfortunately for traders who bought one in mid-February, the S&P 500 has gone virtually straight up in the weeks, surging 13 per cent. The gauge's recovery from an 11-per-cent decline to start the year marked the first time since 1933 it finished a quarter higher after falling at least 10 per cent. The S&P 500 climbed 6.6 per cent in March, its biggest increase since October.
The iPath VIX ETN has absorbed $810-million in fresh capital since Feb. 11, while shares outstanding on the note sit close to the highest since August. The ProShares Ultra VIX Short-Term Futures ETF received $995-million of cash over the same period, while the VelocityShares Daily 2x VIX Short Term ETN, or TVIX, attracted $337-million.
Shares outstanding on the ProShares and VelocityShares securities sit just below record levels -- and each has lost two-thirds in price since mid-February after the drop in the S&P 500 suddenly reversed.
"There was a lot of speculation on the potential extent of the decline," said John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees about $230-billion. "No one knew where the bottom would be. It makes sense that people used derivative strategies to protect themselves."
Market timing has been a challenge this year for individuals and institutions alike. Bank of America Corp. said last month that its trading clients were net sellers of stocks for eight straight weeks, the longest stretch in five years. Mutual funds have seen near-record outflows in 2016.
Bulls are kidding themselves if they think volatility isn't coming back, according to Richard Turnill, global chief investment strategist at BlackRock Inc., the largest ETF provider. Swings in the market were repressed for years by the Federal Reserve's quantitative-easing program of bond purchases, and now that it's over periods of placidity will prove temporary, he wrote in a March 31 blog post.
When the Fed concluded its first round of quantitative easing in March 2010, the VIX more than doubled over the next two months, reaching a peak of 46. When the second round of QE ended in June 2011, the volatility gauge was near 16 and then jumped, averaging about 30 through the third quarter.
"The future path of monetary policy remains uncertain, and tail risks remain," Mr. Turnill wrote. "I do not expect this calm to last, and I see a return to the higher-volatility regime that was the norm prior to QE."
Investors have repeatedly been caught on the wrong side of VIX trades, making a pair of mistimed bets in the second half of 2015. During a week-long stretch in August that saw the S&P 500 plunge 11 per cent, traders placed $15- million of new money into the three long-VIX ETNs. The benchmark gauge erased that entire loss over the following 15 weeks.
In the three weeks leading up to a three-month S&P 500 high reached on Nov. 3, the ETNs captured about $600-million. The equity gauge lost more than 4 per cent in just 10 days.
ETNs can carry additional risks which many investors aren't aware of, according to Mr. Sosnick. They're not meant to be held on a long-term basis because costs associated with holding the underlying index or benchmark can accumulate, more than offsetting potential return.
"There are so many layers of derivatives underlying these trades, of course there's going to be decay," said Mr. Sosnick. "People don't always appreciate how they're layering options upon options in trades like that. Investing like that is never easy."