Ramblings of a Portfolio Manager

The VIX and the “Smart Money Index”

The VIX, or CBOE Market Volatility Index, is an index created in 1993 by the Chicago Board Options Exchange to track market volatility as an independent value, which can be traded on major exchanges. The VIX is calculated based on options prices and activity in the S&P 500 and measures the Market’s expectations of near-term volatility and, thus, many market watchers use it as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism. The VIX itself has been a quite volatile security in recent years, hitting an all-time low of 9.39 in December, 2006 and spiking to 89.53 in October, 2008 at the height of the global financial crisis. Currently, the VIX is trading around 15 meaning that, because mathematically the VIX is expressed as an annual percentage, the market is expecting a 15% change in price (plus or minus) over the next year.

The market has developed a great deal of lore regarding the VIX over the years and it is now often referred to as the "investor fear gauge" because it has a tendency to rise sharply when markets are under stress. Investors, however, tend to be divided over the meaning of the VIX with some seeing it as an indicator of investor confidence and, thus, higher stock prices ahead, while others view it as a contrary indicator of euphoria and complacency implying risk to stock prices going forward. In reality, the VIX is not a measurement of sentiment at all but of implied volatility. Since implied volatility is highly correlated to actual volatility, the rise in the VIX during periods of market turmoil is the result of the increase of volatility itself rather than a change in investor sentiment. Further weakening the VIX usefulness as a sentiment indicator is all the available synthetic methods of hedging risk that have been created over the last decade, which essentially have disenfranchised the S&P options market as the primary source of hedging for many investors.

So what can we make of the fact that the VIX is currently trading at a 52-week low? Well, taking the strict definition of the index, the implication is that investors are not expecting a great deal of market volatility in the near to medium term. Taking the looser “fear” gauge definition, it means that investors are getting comfortable with the levels of the market. By either definition that’s probably good news for individual investors but not so for the “sophisticated” crowd, who make their living hedging and trading off of volatility. This group includes day traders, high frequency traders and hedge funds. In fact, the numbers are starting to bear this out. Through Friday the S&P 500 index was up 7.7% year to date and the Russell 2000 index of small cap stocks was up a whopping 12.8%. With the expectation of volatility along with the “fear” gauge so low, investors are willing to “put on the risk trade,” meaning they are eschewing safer investments for risky assets like small cap stocks. The hedge funds, however, have missed this trade and are showing the impact of the lack of volatility on their returns. Through Friday the HFR Equity Hedge Index was up 1.52%. A more aggressive hedge fund index, the Greenwich Alternative Investments Index, is up only 2.9% year to date. Hedge funds only make the real money for themselves if they make money for their clients and so far that isn’t happening in a big way. So for the hedge funds to have another good year, they need to cover their short positions in hopes the market continues to go up or stay short and pray for a correction. In the first case, that implies further fuel for the “melt up;” in the latter it implies buying support in any pullback. Either way, for individual investors, barring some exogenous event, the VIX is likely to remain low and the slow grind up the “wall of worry” is likely to continue. By the way, has anyone noticed that we stealthily creeped through Dow 11,000?