It’s Low… But Is It Cheap? · 2017-03-13 · » ETFs are increasingly dominant in US trading....

DRIEHAUS CAPITAL MANAGEMENT // 25 EAST ERIE STREET CHICAGO, IL 60611 // 312.587.3800

®

It’s Low… But Is It Cheap?CBOE Risk Management Conference

March 9, 2017

DRIEHAUS CAPITAL MANAGEMENT //

Perspective from the Seat

» Easier said than done » Match your hedge with your exposure

» Don’t stop at “low is cheap, high is expensive”

» Dynamic monitoring—how much of the value proposition is available and how much has played out? » Pre-determined levels for risk management and monetization

» Treat derivative investments/exposures as any other investment across portfolio

» i.e., scenario analysis, weighted avg. probability, expected value outcome, absolute and relative value comparison, etc.

» Sizing considerations—percent of exposure to hedge » Open-ended hedge vs. capped structure (puts, tail puts, spreads/flies)

» Max loss of bps at risk vs. delta-adjusted exposure

» Unintended consequences introduced via trade structure

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Vol Regimes—the Cycle Has Become Condensed

» Post GFC, and increasingly throughout the “low vol” regime that began with the fiscal cliff at the end of 2012, volatility cycles have become increasingly condensed

» Volatility reverts back down as aggressively as it spikes » Search for yield, proliferation of VIX products, and liquidity explain much of the phenomenon

» Most recently, the Brexit result and the US election were key events highlighting the compression of the cycle’s timing

Source: Bloomberg

CBOE Volatility Index

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Is the Proliferation of International Options Use to Follow? The US as a Template

» ETFs are increasingly dominant in US trading. ETF volume in 2016 was up almost 17% over 2015, and 50% vs. 2014, while stocks are up only 7% vs. 2014

» In addition to equity ETFs, non-equity-based ETFs have experienced rapid growth:

» Commodity-based ETF volume is up over 170% vs. 2014

» Alternatives (like volatility) are up over 100%

» Fixed income ETFs are up almost 70% vs. 2014

ETF growth ETF option volume

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ETF Option Growth: The Volatility Asset Class Now Has a Seat at the Table

» International ETF options growth is following a similar path to US ETF options

» With growing presence and asset allocation, volatility products become more sig-nificant in the marketplace

» Low vol, risk parity, and factor funds increase the opportunity to capitalize on market dislocations through use of options

Source: Bloomberg

ETF options volume growth

International ETF volume growth

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International ETF Market Differentiation from US Market

ETFs with greatest 2016 (put + call) open interest & decrease

» No one-stop shop internationally for vol and skew akin to SPX product in the US

» “Best fit” country ETFs vs. more granular US sector ETFs

» Introduces added complexities and unintended consequences » Does it provide any opportunities?

» Currency implications—are actors using alternative proxies for tail exposure (i.e., low-vol FX)

» International ETF option volume tends to follow the “events”

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Real World Examples—iShares MSCI Mexico (EWW)

Source: Bloomberg

» Around the US election, EWW skew priced more muted risk than would be anticipated, given the central focus on economic and currency implications for Mexico, ahead of seminal event

» In contrast to the signals from the currency markets, which saw implied vol reach levels not seen since the 2011 global financial crisis scare

» Concentrated index, with top five holdings accounting for >40% weighting, lends itself to added volatility

EWW three-month skew, past five years EWW three-month skew around 2016 US presidential election

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Real World Examples—iShares FTSE/Xinhua China 25 Index (FXI)

Source: Bloomberg

» Vol & skew—compounding effect

» Multi-year skew highs on top of volatility levels not seen since the GFC

» Questions to ask regarding flashing signals:

» How much stress has worked its way through the system?

» Liquidity event/opportunity to monetize hedges?

» Risk/reward points to monetizing via options over delta, all else being equal

» Potential to take other side of exposure?

FXI volatility and skew during 2015 Chinese Yuan devaluation

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Continuing Forward—What Now?

Source: Bloomberg

» The low-vol regime—length in the cycle and associated risks to be cognizant of

» Hedging: The cost of doing business—it’s definitely low…but is it cheap?

» What’s the objective relative to perspective coming from?

» Opportunistically capitalize when optionality is underpriced

» Mispricing can be in either direction. Don’t forget the right side of the distribution chart.

MSCI iShares Emerging Markets ETF 1-day percent change & distribution

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Looking Forward

» Big themes

» Election outcomes (past & future) rotational impact

» Correlation and dispersion implications

» Low-volatility opportunity—investor cash levels and equity valuations point to stock replacement behavior

» Portfolios considerations

» Hedge when you can, not only when you have to

» Role of options

» Hedge—macro, industry or country exposure, individual event risk

» Opportunistic—relative value and alpha opportunities

» Benefiting from systematic, non-volatility focused players

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French Elections

» April V2X relative to VIX—11 point differential, at wides

» Implying 9% move (near 10% Euro Stoxx 50 Index (SX5E) 1-day move)

» Path of equity index vol tracking ahead of Brexit

» Kink in the curve centered around second round outcome of voting

V2X vs. VIX curves French election is tracking ahead of Brexit

V2X futures are pricing in substantially more french election

risk than VIX futures

As seen in the run-up to Brexit (as well as the US election), US equity vol tends

to find a floor ahead of the catalyst

Source: BofA Merrill Lynch Global Research.

Source: BofA Merrill Lynch Global Research. Source: Morgan Stanley QDSSource: Morgan Stanley QDS

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Rotational & Relative Value Opportunities

» Changing correlation regimes provide long/short opportunities

» During rising correlation environments, contingent hedges price attractively

» In low correlation environments, dispersion is more of a focus

» Will risk-off produce a shifting regime and rising correlations?

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Current Landscape: EFA/EEM

Comparing the two broad International ETFs to isolate European political expectations:

» iShares MSCI EAFE Index Fund (EFA) vol catching up to iShares MSCI Emerging Markets Index (EEM) given country concentration ahead of election risk » EFA: 42% Europe weighting in top five country exposures

» Euro Stoxx 50 ETF 3-month implied volatility at peaks relative to 90-day realized vol, surpassing pre-Brexit levels

Source: Bloomberg

Three-month implied volatility differential between MSCI iShares Emerging Markets and EAFE ETFs

Implied vs. realized volatility differential for Euro Stoxx 50 ETF ahead of European elections

Source: Bloomberg

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Correlations Are Driving Volatility Lower

» Low realized volatility, an extended streak without a 1% decline in the market, and plunging correlations are pushing volatility to multi-year lows

» As of end of February: » 95 sessions in a row without a 1% closing decline—longest streak since December 1995 » 50 sessions in a row without a 1% intraday swing—the longest in history

Source: BofA Merrill Lynch Global Research. Daily data from 3-Oct through 3-Feb 17. Source: Deutsche Bank, Bloomberg Finance LP

Two-thirds of the 5+ vol point drop in S&P 500 index realized vol since the US election can be explained by the -25pt

decline in stock correlation. Average stock volatility, which has only recently fallen, accounts for the other one-third

China (EEM’s largest country weight) has been much less correlated with the EEM than it typically is

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NOTES TO PRESENTATIONThis presentation is not intended to provide investment advice. Nothing herein should be construed as a solicitation or a recommendation to buy or sell securities or other investments. You should assess your own investment needs based on your individual financial circumstances and investment objectives. Driehaus does not guarantee the accuracy or completeness of this information. This data was prepared on March 2, 2017 and has not been updated since then. It may not reflect recent market activity. Driehaus assumes no obligation to update or supplement this information to reflect subsequent changes. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommen-dation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

For Institutional Investor Use Only

©2017 Driehaus Capital Management LLC

Notes

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It’s Low… But Is It Cheap? · 2017-03-13 · » ETFs are increasingly dominant in US trading....

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