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Are We Headed for an Index Bubble?
Traders Magazine Online News, May 15, 2017
Bubble? What bubble?
In a blog shared with Traders Magazine, Jared Dillian, former ETF Head Trader for Lehman Brothers, wrote that while assets have been fleeing actively managed ETFS and funds and into passively managed ones, is concerned the Index sector could be heading towards a bubble.
“I want to talk about the idea that this strategy has become so popular that it is a bubble in and of itself,” Dillian began. “This is a frequent topic of discussion online. The index fund bulls/promoters usually point out that just a small fraction of assets have switched to passive—there could be a lot more to go. That is true. The index fund bears/detractors point out all the distortions that are happening from indexing.”
Such as:
- It has ruined long/short strategies
- It is screwing up corporate governance
- It is causing valuation distortions
Dillian reminded that if one lived through the dot-com crisis, there were poople day-trading at their desks at work, cab drivers giving riders stock tips, and so on. Mania. So =, he asks, what if indexing is a mania unto its own?
What follows is Dillian’s blog.
I’ve been yapping my trap about these vol-selling monkeys for some time—we may have finally reached peak vol absurdity.
As you may have seen, the VIX dipped under 10 on an intraday basis the other day:
Meanwhile, short interest has reached an all-time high in VXX, the ETN that is supposed to track the VIX.. Remember, if you buy VXX you are getting long volatility, so basically what we are seeing is an overabundance of people rushing in to sell volatility… at the all-time lows.
No bubble here.
We spent last week talking about bubbles—is there a bubble in short volatility strategies? I think there might be.
Please stop and read this terrific piece by Dean Curnutt, CEO of Macro Risk Advisors, on Bloomberg View. In it, he talks about the idea that financial insurance is different than conventional insurance. With insurance against hurricanes or fires, for example, the event you are trying to insure against is truly exogenous. Hurricanes (for all intents and purposes) are independent events, and occur without respect to how many people buy insurance.
But that is not the case with financial markets insurance (like options). As opposed to earthquakes, which are exogenous events, a crash (caused by a rapid unwinding of positions) can be an endogenous event, as Curnutt explains. People put on a trade, it works, which encourages more and more people to pile in… until it eventually stops working. Then everyone will want to get out—all at once.
As I have written before, selling volatility has worked so well for so long that many people believe it to be free money. Shorting VXX works when volatility goes down and the term structure of volatility steepens. What happens if volatility goes up and the term structure inverts—and stays inverted? Road pizza.
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