Volmaggedon and the Rise of Passive

demographic storms, XIV, and the *flows*

This is a piece in partnership with Simplify around the rise of passive investing, the XIV implosion, and the current market environment.

YouTube/podcast up!

The Rise of Passive

I own a target date mutual fund in my 401k. It was bestowed upon me when I began my career journey, and I have stuck with it ever since. But there is an interesting relationship between people like me (and many others) who passively invest in target date funds - and the larger market macrostructure. 

The question becomes - what impact do these passive flows have on the market? What does it mean for how we think about valuation and fundamentals (do those even matter anymore)? 

This piece will focus on:

• Correlation and Volatility

• Volmaggedon 

• Passive Indexing

• Demographics and Market Efficiency 

• The Power of Flows

• Bitcoin fixes this (?)

Correlation and Volatility

In 2017, the market was just FLAT. There were measly 25 bps move days, and that was a *big move*. The market wasn’t really responding to anything, which led to a depressed level of volatility. 

This is because volatility is a function of a variation in prices - so if the market is hardly moving, it makes sense that the variation of prices would be smushed. When the market is depressed like this, it becomes more correlated -  it just sort of ticks upwards (as a function of passive flows and volatility selling, which is what we will touch on later).

If the market begins to move - which it does eventually, when responding to exogenous shocks, volatility begins to move - we see correlations begin to rise:

• 0-25 bps move: correlations relatively flat

• 25-50 bps move: correlations begin to rise

• 50-100 bps move: correlations begin to SPIKE

So zooming out here: the market is more correlated than it's ever been, but this is hidden primarily because the market barely budges. But when the markets do move (aka move up by 50 bps), they are going to show higher correlation, and with higher correlation comes higher implied volatility. 

The kinetic energy of a volatility spike is there - but it doesn’t show. Why don’t the markets move, and why don’t we see a lot of outsized movement? Systemic volatility selling!!

A lot of people are scraping for yield in the current environment - and people will do anything for a few extra bps of return. Everyone wants to enhance their yields, and one way to achieve that is through going short volatility (aka you think that volatility is going to remain flat/depressed).

For example:

• You buy a call

• Dealer has to hedge - so they short the S&P to delta hedge 

  • This eliminates the directional component of the overall trade

So what happens if the markets move?

• Market goes up - Your call gains delta - dealer needs to short more of the market to balance that out! Market goes down because the dealer is moving.

• Market goes down - Same thing, but opposite. The dealer needs to buy back shorts, pushes market up. 

So the market exists in this in-between world - a pole balancing, essentially.

And now more than ever, it operates within this small realm of possibility. Algorithms have made this pole balance even better - the band of movement has gotten even tighter (aka market moving one way and then structurally moving the other) - and the overall market has shifted to being more precise and compressed. (Here’s a good video to demonstrate)

As long as nothing spooks the algorithms, they should stay in this tight band of movement. But exogenous shocks did happen - COVID, most recently. And Volmageddon, most notably. 

Volmageddon

XIV died in Feburary 2018 (this a brief, non-technical overview of its death). A ~$2bn entity, it collapsed within itself. It was an exchange traded note (ETN) not an ETF - and it’s movement was linked to the INVERSE of futures representing the VIX (a product named VXX). More specifically -

The VelocityShares Daily Inverse VIX Short Term ETN provides -1x leveraged exposure to an index comprising first- and second-month VIX future positions with a weighted average maturity of 1 month.

If VIX goes up (volatility increases), XIV falls. The market was slowly ticking upwards - it didn’t seem like there was an exogenous shock that would make anything spooked out.

But slowly, the beta of the VIX to the S&P began to rise. Normally, this is somewhere between 4 and 8, but the weeks before Volmageddon it was much higher, ~22. This means that the VIX was very sensitive to any sort of movement in the S&P. 

• At a super high level, because the XIV was 100% inverse to the VIX, IF the VIX doubled at any point, the XIV would go to zero

On February 2nd, 2018 the Fed changed reserve requirements on banks. That was a spook on the markets.

• Before: If you owned equities as a bank, you had to hold capital against a 30% one day decline. The “equivalent” risk exposure for a short vol position was a 10 pt jump in the VIX. 

  • But the thing is a 30% decline in the S&P is NOT a 10 pt jump in the VIX, it’s roughly a jump in the VIX to 240! With the VIX at 13 in the days before Volmaggedon, even a move to 26 (much less 40 or 50) would cause the XIV to crash all the way down to zero. 

    • Which is what happened -- the VIX spiked to 50 on Feb 6th 

  • With all the banks expressing their equity positions as short vol - remember it’s much more capital efficient to do it that way

    • The short vol position was very crowded 

• After: The Fed changed the risk exposure from 10 pts to 30 pts - which freaked a lot of people out. Everyone was trying to cover and get insurance. It’s estimated that there was $1T exposure via the short vol positioning.

So there was an exogenous shock on the system, and it resulted in the implosion of XIV. Market got spooked. Volatility spiked, XIV got speared. But the big question is how could something like XIV 1) exist and 2) impact the market this much?

Passive Indexing

An underlying theory here is that passive flows change the behavior of the market. So think about a river running over a stone over time - it’s going to gradually change the face of that stone. 

• Passive Flows: Vanguard, Blackrock etc, all invest passively with most of their funds - meaning that they just invest to mimic the performance of a certain index (like Vanguard’s VOO tracks the performance of the S&P 500). 

  • This is fine - why ~wouldn’t~ you want to match the performance of the S&P? Sounds better than underperforming it, right?

• Active flows: Active managers actively try to BEAT the benchmark whereas passive managers are literally like - all we have to do is MATCH the performance of the benchmark.

  • This is fine too! Why wouldn’t you want to beat the S&P?

But the issue here is the stone changing shape - so those passive flows will KEEP on running, even when market fundamentals are like “whoa, maybe the water should stop.” Vanguard doesn’t care if the market is at all-time highs. They are still gonna buy, whereas active managers are more discerning in how they price out what they are buying.

• Vanguard essentially dollar-cost-averages themselves into every single stock every month - “oh wow, the market is extremely overvalued? We still have to buy.” (they literally do have to buy because of fund mandates) 

These flows ends up pushing the market up (stonks go up) - more so than anything else.

Think about it this way:

• Imagine that an active manager goes to the supermarket. They are going to use coupons, price-match items, make sure that they are getting the BEST deal possible (they go to a discount grocery store). 

• Whereas passive managers are going to go to the store and buy things at 2x the price (they go to Erewhon). 

So if you have a bunch of people that are paying 2x the price, the market is going to normalize towards that price. The line to Erewhon is out the door - and more and more passive flows are trying to get in.

Demographics and Market Efficiency 

This is a function of demographics too, as most things end up being. Most people my age (myself included) have our 401ks set up with target date funds, which are mostly passive. 

• It shows up in the numbers too. Those under the age of 40 are ~90% passive whereas those over 65 are more like 20% passive. This dichotomy is really important - for a few reasons:

Source: Mike Green

• Boomers retire: As the Boomers go on to retire, they are going to take their actively managed $$ out of the market

  • This skews exposure to passive

• Gen Z ages: As the younger generation gets more jobs and set up retirement accounts, those are going to be set up passively. 

  • This skews exposure to passive. 

• Perfect demographic storm: So as both Boomers and Gen Z age, the skew towards passive grows.

This shift to passive results in the S&P 500 increasingly behaving like a single stock - all the stocks are correlated and are moving together. 

• If passive flows go into Erewhon and pay the 2x the price for nectarines, eggs, and milk, all of those prices are going to move in a similar function to one another - up. 

Right now, passive market share is only ~44% of the market, but this correlation will continue to increase (due to demographics etc) and exacerbate this relationship.

The idea for a long time was that the market will “be efficient” until it gets to like 80-90% passive (that’s what John Bogle himself said). The theory now is that we are much closer to “loss of efficiency” than we thought - and it doesn’t take 80-90%, it takes more like 50-60%.

Source: CFR

Because everyone starts playing in the same sandbox with the same tools - there’s only so much time until the sand starts looking the same. People are buying the same stuff, buying as it goes up, and then the stocks start trading like each other. This leads to a few things:

• Price suppression: The passive flows will pay any price - Tesla and the S&P is a great example. Vanguard will pay any price for Tesla, and will go in, even if the price is bid up. 

• Higher volatility: If the entire market behaves like a single stock, that is going to drive volatility, and push correlation. 

  • Think of diversification - if you are 100% exposed to TSLA, you are 100% exposed to the fluctuations in the price of that stock - but if you have a diversified portfolio, that provides more security. The market is now trading like a TSLA - a single stock

• Inelasticity: Think of insulin - you have to buy insulin if you need it to manage diabetes - it’s an inelastic good. It’s the same with markets here - they have an element of inelasticity where passive managers HAVE to purchase things.

This leads to an out-of-whack relationship between valuation and flows.

The Advent of Passive Investing

Historically, there has been a model of mean reversion 

• If valuations are really high, people are going to sell and be less willing to buy

  • If the price of a home 4x’ed a lot more people are going to want to sell versus wanting to buy

• If valuations are really low, people are going to buy and are less willing to sell.

  • Same thing here - if a price of a house falls 4x - people are gonna want to buy that home

But this is no longer the case. Because the marginal investor doesn’t pay attention to valuations. There is just money flowing into passive, which puts upward pressure on valuations. Which is fine(ish) as long as the market goes up.

Then the problem is what happens if the market falls - what happens when people freak and the sell feedback loop begins? What happens when people pull out of Vanguard and they can’t cover that?

The market craters, like it did in March 2020. 

• You would think that things would be calmer right? 

• Surely the passive flows would soothe the markets - but it’s the opposite because of the lack of liquidity.

Passive holders don’t react to anything - earnings, reports, news. Vanguard just sits there, and the active managers trade amongst themselves in a reduced liquidity environment which can result in exacerbated moves.

This creates a mean expansionary environment

• Instead of active players “setting the price” through valuation models and with thought towards returns, it just becomes passive players gobbling everything up.

• So there is no “diversification” within the S&P 500 because of that, as everything trades as one entity.

Which is why the market continues to tick upwards - it’s relative to flows. The markets absorb the passive flows. And as money shifts from active to passive, things get even funkier.

• A move from 0 to 1% passive as it goes into equities changes valuations by more than 1% as valuations are pressed upwards by passive flows

  • This circles back to the demographic shift: people get older, more money to passive

Vanguard estimates that by 2023, 80% of all 401K accounts will have a SINGLE product in them -- a target date fund. It seems super harmless to have this structure (oh I will just match the S&P) but it’s actually a big issue, because the flows now have no taste, they have no preference.

• Think of it like this - a restaurant on Yelp is rated 5 stars because it has really good food. Someone sat down, ate that food, said “yes this is GOOD, 5 stars.” 

• But if someone was eating at every single restaurant, and shaking salt all over the food, it would all taste (relatively) the same. They would have no preference - they would rate everything 3-stars. 

So with passive flows, they rate every single restaurant (company) 3-stars because they shake salt all over it, and it becomes really hard to discern the good from the bad.

Passive can result in a misshapen market structure. 

• When you think of any portfolio construction theory etc, the goal is to have an ~expected return~, which is a function of historical returns with some volatility.

• But passive flows have disrupted the model, shifting the dollars in the market towards people with staying power - passive investors.

• Prices have to respond to those that stay, which creates a liquidity crunch for those that want to sell - and pushes prices up.

Zooming out here - you might say, “wow it sounds like the market is a function of flows, not any underlying fundamentals!”

And you could be right.

The Power of Flows

There is a beta to flows, meaning that flows can have a very big impact on funds that grow large (like Cathie Wood and ARK) and the price becomes a function of flows. Flows can prop up the market - which is really bad if people start to pull out of the market, because that implies that the market would crater. 

No flows → market doesn’t go up.

The market structure has changed.

• Back in the 1970s, Fidelity had ~2% of the market, and that was the LARGEST share anyone had. 

• But now Blackrock, Vanguard, StateSteet, Fidelity, etc all have ~7-9% of the market, meaning that roughly 4 firms own ~40-50% of the market. 

With their passive flows. 

You can think of them more like Blackvanstatedelity because they all move passively - so ~50% of the market and 80% of the flows are going to be moving relatively the same at all times, into all the same companies.

This puts pressure on the efficient market hypothesis for sure because flows aren’t information on price and valuation (passive flows at least). Now the model is driven by passive - and detached from fundamentals. Instead of “reverting to the mean” the market is now a mean explosion dynamic (aka continues shooting upwards) and becomes separated from that relationship entirely. 

Does Bitcoin fix this?

HODL: The HODL sentiment is similar. It is passively holding bitcoin, no matter what. Same sort of inelasticity that shows up in the markets, with whales driving most of the inflows. Institutions have gotten their FOMO, and now are moving flows towards that. 

We have operated under the assumption that prices move because of information - but logically, they move because of transactions too. And because $500bn came into the market this year (with roughly 2/3rds of that going to BlackRock and Vanguard) the passive flows are only get even more exacerbated. 

Vanguard is always buying. They have a trillion dollar fund, so they almost have to be. They own almost every single stock and are buying all the negative yielding bonds. They even bought the Austrian century bond, which is incredibly unattractive - but Vanguard still owns it. That creates essentially a wind tunnel of money. Supremely risky - and important to hedge against.

What is a solution?

BROUGHT TO YOU BY:

How do you retain protection in a market environment that is so wacky? Simplify has several strategies that protect against catastrophic events, and hedge against events like Volmageddon. The strategies are designed to provide an attractive income stream and source of diversification, without the risks inherent in high yield bonds, through short VIX positioning coupled with option overlays to mitigate against potentially adverse moves in the VIX.  

Simplify Asset Management was founded in 2020 to help advisors tackle the most pressing portfolio challenges with an innovative set of options-based strategies. By accounting for real-world investor needs and market behavior, along with the non-linear power of options, our strategies allow for the tailored portfolio outcomes clients are looking for.

*This is not investment advice. See https://www.simplify.us 

Final Thoughts

Passive flows are having an impact on how the market is structured, and shifting market dynamics to an element of *stonks always go up*. It’s important to understand the underlying mechanics, and how that ultimately impacts the entire functioning of the market.

It has increased access sure, but it also has changed the ecosystem of the market functionality.

Volmaggedon was a great example of a product that ended up driving the market. Passive flows are driving the market more and more - which could be very painful if we have another exogenous shock (like Volmageddon). There are strategies you can implement to protect against the downside here, but it’s important to understand *why* the downside needs to be protected, and how the plumbing of the system has changed - and how that could impact market returns moving forward.

Disclaimer: This is not financial advice or recommendation for any investment. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.