SINGAPORE (Aug 3): As investors allocate their portfolios on hopes of continued global economic expansion, it seems the entire world is shorting volatility, says David F. Lafferty, Natixis senior vice president, chief market strategist.

In Natixis’ capital market note for July, Lafferty explains how super-low volatility in global markets have spurred a new sub-industry in shorting volatility with myriad exchange-traded funds (ETFs), inverse ETFs, and derivative products that usually have a ‘V’ in their tickers.

“During this period of low volatility, shorting volatility through VIX has become incredibly profitable. To the casual observer this may seem odd: Shorting an investment profitably requires borrowing and selling the asset now while later repurchasing it at a lower price,” says the strategist.

“But volatility hasn’t been ‘falling’. It fell dramatically after the Great Financial Crisis and, with some sporadic exceptions, has remained mired below 15 in the past several months – and more recently below 10,” he adds.

This is because given the structure of the VIX futures market, profitability from shorting volatility only requires that the structure for the futures stays about the same, instead of lower VIX levels. In his words: “Shorting volatility is really just a bet on the status quo – that markets won’t change that much.”

This also explains how investors have generated profits shorting VIX, even though it hasn’t gone much lower than 9–10.

As the entire outlook for risk-on assets is predicated on the continued and synchronised expansion of the global economy, Lafferty says that the current view of most investors with this mindset is hence what he describes as one giant short on volatility.

“Without the strengthening fundamentals, what would we be left with? Extended valuations, rising geopolitical risks, and central banks that are withdrawing the punch bowl – albeit slowly. There is no small irony that investors who would never make a bet on shorting VIX at these levels think nothing of being long stocks, high-yield bonds, and commodities,” he observes.

However, Lafferty emphasises that this view does not mean investors are making a mistake by remaining allocated to risk assets, nor by betting on the status quo.

Instead, he believes there is a clear implication that investors should be seeking safer or lower-risk ways to remain invested by maintaining participation in risk assets, but with less downside. This means lower-volatility strategies or option hedging in the case of equity markets, and dialling back high-yield exposure toward BBB-rated corporate bonds, bank loans or other ‘lower-beta’ strategies.

Investors should also continue to remain hyper-vigilant about the global economy and earnings trends, he adds, as obvious as that might be.

“It is even more important today as neither central bankers nor troublesome valuations are an investor’s friends. Right now, the entire world is short volatility. Remember that as you allocate your portfolio,” says Lafferty.