When Vix shot from 17 to 37 in one trading day on February 5 this year, driven partly by a technical feedback loop as XIV exchange-traded notes collapsed in value, the first question asked was ‘who saw it coming?’. The second was whether they did something about it. Some did.
“We downloaded the XIV prospectus and found the clause saying that if it lost 80% intraday they would start liquidating,” says one portfolio manager at a US asset manager. With Vix trading at around eight or nine versus a historical average around 20, such losses seemed plausible.
The firm looked for a product that could benefit from intraday moves in a blow-up of the CBOE’s Vix volatility index that such an event would cause, but something that would also have a “decent” cost of carry, he explains – “we didn’t want to lose a lot of money if nothing happened”.
The asset manager settled on an offering from JP Morgan: the bank’s US Volatility Momentum QES Index. Come February 5, that decision made the difference between being up or down, the portfolio manager says.
The investable index was a big winner for JPM, returning 14.5% for clients that day.
Back in September 2017, the dealer launched the momentum index to capture intraday patterns in how the Vix trades – specifically, its tendency to gather momentum as it gets closer to the end of the trading day.
The strategy the index represents goes long Vix futures if the market moves above a trigger point based on the previous day’s levels, but only if the curve is in backwardation. Such a scenario is relatively uncommon in Vix futures and indicates stress in the market that suggests the index is likely to be rising during that session.
The product has been the fastest growing in JPM’s QES index family, though the firm won’t disclose publicly the exact amount it has traded referencing the index.
In the 18 months running up to February, clients had been looking for ways to improve on traditional hedges with strategies that would carry more cheaply, do better in a stress event and lock in profits when a reversal struck, explains Emmanuel Naim, who runs equities structuring in the US.
Pension funds and insurers were looking to protect improved solvency positions resulting from rising yields and hedge against potential falls in their long equity portfolios.
In a market like the Vix market, where liquidity can be very sparse, that focus on optimising liquidity and mitigating market impact in trading sessions is hugely importantArnaud Jobert, JP Morgan
Alternative risk premia funds, too, were looking for strategies that would protect against the recorrelation between strategies in sharp risk-off moves, a fear that proved well-founded, as many risk premia strategies struggled through 2018.
Other banks offer similar products, but JP constructed its index with two features that set it apart.
The index references tick data – meaning the algorithm behind the index can trade at any point in time; also, the algorithm adjusts its notional exposure depending on the live market liquidity through the day.
Partly, the benefit is cost. By trading second-by-second through the day rather than at a finite number of junctures, JPM is able to reduce market impact.
“In a market like the Vix market, where liquidity – as we saw a lot this year – can be very sparse, that focus on optimising liquidity and mitigating market impact in trading sessions is hugely important,” says Arnaud Jobert, who runs equities structuring in Europe.
Pointing to episodes of thin liquidity, such as in February and more recently October, he says: “If you use simplistic VWAP or TWAP over a given time window, you could be 100%, 200%, 300% of the daily volume at a given point in time. I don’t need to quantify what the market is going to do if you go live with a big size and you are such a big portion of the market.”
Perhaps the biggest advantage, though, is ensuring the strategy captures maximum upside in a volatility surge.
“Some other long vol hedging products didn’t even react in February because they only rebalance at the end of the day,” the US portfolio manager says. “Being very responsive is important for us. This strategy is a very good complement to other strategies we have.”
Amplifying market moves
Motivation for the product came from research by Marko Kolanovic, the bank’s high-profile quant analyst known for his sometimes hair-raising predictions about technical flows from systematic market players and banks themselves.
Kolanovic has been writing since 2008 about how dealers can amplify market moves in the underlying when hedging options positions.
Investors typically use options as protection against market dips, he has argued, leading to an imbalance in demand and leaving dealers with a short option position to delta hedge. Typically, banks hedge towards the end of the day – selling the underlying as the market drops or buying as it rises. In a volatile environment, dealer flows can have a meaningful impact on the market itself.
Those market dynamics were added to in February by huge technical flows, as inverse Vix products collapsed. Regardless of the fortunes of such short-Vix products, which have been largely wiped out, Jobert says the popularity among institutional clients of Vix call spreads as an insurance product means dealers on the other side of these trades will often still be short gamma on Vix.
While the Vix momentum index has enjoyed a striking year, its development and success also reflects a longer-term shift in investable indexing.
With its QES platform, JPM has put in place the apparatus to ingest tick data from exchanges and has established the legal template for a family of indexes referencing higher-frequency data.
To date on the QES platform, JPM has launched intraday momentum indexes for the S&P 500 and Nasdaq in addition to Vix. The bank also draws on its intraday capabilities in volatility arbitrage strategies and to smoothe delta hedging in systematic volatility carry programmes. The firm is exploring opportunities outside equities.
The bank spent a year-and-a-half building the technology infrastructure and documenting the first indexes, Naim says.
As he sees it, through these efforts, JPM has addressed a common criticism from hedge fund rivals aimed at investable indexes: that banks are tied in to executing at the close and so suffer the effects of their own market impact.
“Improved execution has always been one of the differentiating stories that quant hedge funds highlighted against investable indexes. That argument has some grounds to it. Investable indexes have by and large been close to close,” Naim says. “With this platform and its extension to new asset classes, we are breaking that barrier.”