Retail investors linger to buy VIX ETFs as Trump’s presidency appears risky

Retail investors continue to buy VIX ETFs albeit at a slower pace than last year. Rising VIX ETF exposures are reflective of skepticism and general lack of conviction by retail investors, who are the main users of VIX ETFs, and who see the current combination of very low realized equity volatility and record high equity prices as rather unsustainable.

The collapse in realized volatility and the current very low level of the spot VIX index is inducing retail investors to buy VIX products on the expectation that volatility will increase. After all, uncertainty is high and the risk from negative Trump policies looks significant. And it was only recently that we were in an environment of high volatility and high uncertainty.

The VIX is currently under 12 compared to levels over 20 into the US election in November last year, or over 25 post-Brexit last year. So establishing a long VIX exposure via ETFs at current levels appears on surface attractive as it implies a large potential upside, in the case that a negative shock, such as negative Trump policies, pushes the VIX up to much higher levels.

But there is a natural limit: as more money flows into long VIX ETFs (refer above chart), the VIX futures curve steepens (refer above chart) making the negative roll more onerous and the cost of holding a VIX ETF more prohibitive. As a result of the steepness in the VIX futures curve, popular VIX ETFs are currently losing close to10% per month due to negative roll. If no negative shocks materialize over the coming months, it is likely that negative-carry long-VIX positions are taken off, exerting downward pressure on the steepness of the VIX curve, from currently “bubble” like levels.

The skepticism of retail investors is also revealed in their fund flows. While retail investors have bought a decent amount of equities in the last two months of 2016, during the first few weeks of 2017, retail investors bought more bond funds then equity funds. As a result, the gap between equity minus bond fund flows shifted lower into negative territory as shown in Chart A1 in the Appendix.

The difference between flows into Equity and Bond funds: $bn per week. The flow includes US domiciled Mutual Fund and globally domiciled ETF flows. We exclude China Onshore funds from our analysis. The thin blue line shows the 4-week average of the difference between Equity and Bond fund flows. Dotted lines depict ±1 St.Dev of the blue line. The thick black line shows a smoothed version of the same series. The smoothing is done using a Hodrick-Prescott filter with a Lambda parameter of 100.