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Short-Volatility Complex Returns, Defying Wall Street Alarm

(Bloomberg) -- Here’s one to file under the market’s memory-loss.

The volatility complex -- the selling or shorting of options tied to U.S. stocks -- is back with a vengeance, shrugging off February’s vol-mageddon in its wake.

Hedge funds hold the most number of short positions on the Cboe Volatility Index since late January -- before the record spike in the gauge that wiped out over $5 trillion in global stocks and jolted investors from their complacent slumber.

Meanwhile, money managers are back to selling products linked to equity price swings en masse, either to speculate conditions will remain subdued or hedge underlying exposures.

“Combined with a more benign view on the cycle than us, some argue that this is still a time to be selling volatility,” Morgan Stanley cross-asset strategists wrote in a Monday note. Highly valued assets and an aging U.S. economic cycle suggest that view is wrong, the bank said.

Risky Business

The luminaries of high finance sound worried. At JPMorgan Chase & Co.’s annual quant summit in New York last month -- featuring BlackRock Inc., Man Group Plc and Pacific Investment Management Company LLC -- a volatility event was dubbed the second-biggest risk to quantitative investing after a geopolitical shock.

Another warning: Volatility selling has the biggest potential downside among strategies that weigh assets based on their projected sources of returns, or risk-premia investing, according to the JPMorgan survey. The poll canvassed the opinion of up to 270 investors overall.

Traders are ignoring a hailstorm of bearish missives, however, lured by the prospect of easy returns. Hedge funds and other leveraged managers hold the most short VIX futures contracts since Jan. 23, data from last week show.

Hedging pain

Selling volatility isn’t just a favored sport for stock bulls, it can offer a reliable source of income for those seeking to hedge. Take investment manager Plurimi Wealth LLP, which three weeks ago flipped to a short VIX position, driven largely by the belief the gauge would fall back below its European counterpart.

“We are short U.S. equities, so short VIX has a very high carry and helps you fund a short position in equities,” Patrick Armstrong, chief investment officer at the London-based firm, said in an interview with Bloomberg TV. “It worked out very well.”

Shorting the VIX can buffer a bearish equity position, as the gauge trades in the opposite direction of the S&P 500 about 80 percent of the time.

One reason for the product’s enduring appeal: the VIX futures curve, which tracks the implied volatility of U.S. stocks over time, looks similar to recent years in the bull market, according to Armstrong. That suggests warnings that global markets have entered a new regime of higher equity price swings look, for now, premature.

And being bullish on risk is paying off. The SG Volatility Trading Index, which tracks hedge funds using volatility trading and arbitrage strategies, gained 2.9 percent in the first quarter, its biggest three-month advance since 2010. Shorting the VIX outright has also reaped returns, as the gauge has declined to trade at its lowest level since Jan. 26.

But to Tony Dwyer, equity strategist at Canaccord Genuity Inc., there’s a high likelihood that volatility resurfaces. One reason to worry: even a modest uptick in monetary anxiety could roil risk assets on the current trajectory.

The Federal Reserve’s policy uncertainty index, for example, shows a historically low reading that “sets the stage for increased volatility as each major economic release hits the tape,” he said. The gauge has touched this level only four other times, each of which was followed by a sudden swing in prices.

“The cycle is far too advanced to give vol sellers enough time to be able to withstand mean-reversion,” Morgan Stanley strategists wrote.

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