Sometimes the actual catalyst for a correction is obscure and completely unexpected. This selloff was not precipitated by Friday’s jobs report, not by rising interest rates, not by rising inflation expectations, not by a change of leadership at the Fed, not by credit market stress, not by weak economic data, and not by weak corporate earnings announcements. To the contrary, the global macroeconomic and corporate earnings backdrop is strong. And while those other factors are concerns, they don’t represent near enough risk to account for the massive increase in volatility we saw yesterday.
No, what we’re seeing is a “dislocation in how volatility is traded,” according to one CNBC reporter. Some professional investors/hedge funds (and also apparently retail investors) have been using complex derivative funds to bet on continued low stock market volatility. These funds are based on the VIX Index, which uses the options market to predict stock volatility, and they are often leveraged. In other words, they are inherently very risky. Well, as we all know volatility suddenly returned, and these funds absolutely tanked. Bloomberg says more than a dozen of these funds were halted after their “values sunk towards zero.” Today, Credit Suisse announced it would close its VelocityShares Daily Inverse VIX Short-Term ETN (XIV). It fell 80% before being halted.
Typically, when hedge funds get caught holding complex, suddenly illiquid securities they are forced to sell what they can—common stocks—in order to deleverage. Hence, yesterday’s stock market plunge. And there could be more to come in the near-term. Looking back to 2008, we know that three problems took down financial markets: excessive debt levels, a lack of liquidity, and inadequate diversification. And two of these factors, leverage and illiquidity, helped cause this correction. Sometimes, the lure of financial innovation is too strong. In a CNBC interview, Carl Icahn said, “When you start using the market as a casino, that’s a huge mistake” And these leveraged derivative funds are a “casino on steroids.”
To us, this event represents a warning signal to investors, just like the flash crash on August 24, 2015 did. Risk management may not always be in vogue, but it is always critical as a part of your investment strategy.