Were our fears inflated?

Were our fears inflated? Nothing like a little play on words to end the week. You might think we are referring to the equity market recovery which is posting the best weekly return since 2011. Or the Consumer Price Index (CPI) report released earlier this week which printed above expectations (0.5% for January vs. 0.3% estimate) but with an average 2.1% year-over-year change which is not terribly scary. Instead, I am talking about what is commonly called the “fear index” or the implied volatility of the S&P 500 formally called the VIX. Typically when equity markets decline and market sentiment turns sour, the VIX rises thus why traders look at it to gauge the balance of fear and greed. Fear showed itself in significant fashion the past few weeks during the market correction. The VIX went from a sleepy level around 14 (long-term average is in the middle teens) before peaking close to 40 and now subsiding. A few days ago an anonymous whistleblower came out this week claiming there has been manipulation of the VIX which is now prompting an investigation.

While a seemingly arcane part of the market, there are several reasons this issue is worth considering. First, there are many investment products linked to the VIX which have been “sold” by brokers and have become notorious in the recent downturn. For example, the triple-levered inverse exchange-traded note linked to the VIX which was essentially wiped out when the VIX spiked. Or, “naked put selling” (i.e. selling the ability to have you buy the asset at a set price for a period of time in exchange for a premium paid to you up front) as a strategy to earn return which then destroyed capital as equity prices fell and the VIX spiked making it doubly expensive to roll the options and manage risk during the uncertainty. However, the whistleblower indicates that even those following more sound approaches to earning return from market volatility may still have experienced significant opportunity cost over time as value was leaked to the perpetrators. Second, while most people are not directly invested in the VIX, it is an indicator which is monitored to gauge market expectations and risk. Manipulation of markets creates misinformation which can have secondary and tertiary effects through capital allocation decisions. Third, and perhaps most importantly, it is yet another alleged incident which weighs upon the public’s mind and reduces their confidence in the fairness of the financial system. Trust is the cornerstone of any capital system, and a loss of confidence is really something to fear.