Back in October, we discussed a report that several hedge funds have sprung up in recent months with just one strategy in mind: preparing for the arrival of the “fat tail”, i.e., betting on a sharp spike in depressed, comatose volatility. One among them, was One River Asset Management, a manager of $700 million led by Eric Peters in Greenwich.
Today, in his latest letter to investors, Eric Peters explains his logic and reasons – which are hardly unique and have been discussed here repeatedly over the past year – why he believes that for vol, the only way is up.
From Eric Peters Weekend Notes, Jan 7
To sell implied volatility at current 50yr lows, investors must imagine tomorrow will be virtually identical to today.
They must imagine that bond yields won’t rise despite every major central bank eager to hike interest rates and exit QE.
They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by structurally decelerating global growth.
And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure.
I can imagine a few of those things happening, but neither sustainably nor simultaneously.
It is much easier to imagine a tomorrow that looks different from today.
Also consider that investment banks and asset managers have always devised creative strategies to make money once asset valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated.
Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.
As volatility has declined, investors have had to sell even more of it to sustain sufficient profits.
This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices.
This in turn reduces volatility, reflexively.
Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, this market is exposed to a historic reversal somewhere along the path to policy normalization. Which has now begun.
And visually, the feedback loop works until it doesn’t.