Who's Afraid Of Low Volatility?

Investors are betting on calm conditions ahead, but those very wagers could upset markets.

- Peter Coy, with Wendy Soong

You can speculate on stocks going up or stocks going down, but you can also wager on how extreme the ups and downs will be. Investors who bet on calm have done stupendously well lately. As in a 180 percent return over the past year on the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, which is one of the most popular vehicles for bettors on low volatility.

Trouble is, as the late economist Hyman Minsky observed, stability creates its own instability. People get overconfident in their investing savvy and overpay. Professional investors who thrive on volatility find it harder to make a living when markets are calm, so they invest with borrowed money to amplify their meager returns. That makes them as vulnerable to a price decline as any indebted homeowner; margin debt has grown as rapidly as stock prices since the 2009 market nadir.

The VIX, a gauge of expected stock market volatility, finished below 10 on only 26 trading days from 1990 through Aug. 2, 2017, and 17 of those placid days occurred since the start of May. The persistence of extreme calm may have pushed investors toward strategies that could blow up if volatility returns. “It’s not that volatility is low. It’s how long it’s been low,” says Ramon Verastegui, a managing director at Société Générale SA in New York. The bottom line is that highflying stock markets in the U.S. and other countries are more vulnerable to a big sell off than one would think from looking at the VIX alone.