We’re late to this, but JPMorgan last week published an interesting note that subtly apportions some of the blame for low levels of market volatility on an options fund run by . . . JPMorgan Asset Management.
The bank’s burst of friendly fire comes just a few weeks after the Bank for International Settlements became the latest to flag that the explosion of option-based investment funds may be contributing to the mysterious compression of the Vix , which for months has held below its historical norm.
Per JPMorgan’s Marko Kolanovic and team:
Call overwriting ETFs have become a large source of volatility supply that has been increasingly weighing on market volatility levels, in our view. These ETFs are suppressing both short-dated implied volatility (via option supply) and realized volatility (as dealers hedge the resulting long gamma positions).
Option-based ETFs are currently supplying ~$5Bn of gamma, up from just ~$0.2Bn three years ago, the vast majority of which is coming from call overwriting strategies. Of this gamma supply, ~70% is on the S&P 500/SPY options,~25% is in Nasdaq/QQQ, and the remainder is a variety of index/ETF exposures (mainly Russell 2000, MSCI EAFE, and MSCI EM) and single names (mainly TSLA and NVDA).
(A quick and dirty note on the Greeks: ETFs selling tons of options necessarily lowers the price — measured in terms of implied volatility — of said options. Dealers who are long gamma are driven to buy equities when the market is falling and to sell equities when the market’s going up. If that’s done at scale, it can crimp realised volatility by cushioning sharp sell-offs and rallies.)
The bank estimates that total assets under management in US-listed option ETFs have jumped by about 700 per cent to around $100bn over the past three years. Of these, call overwriting ETFs are the largest, accounting for almost two-thirds of AUM.
However, JPMorgan itself happens to be by far the biggest player in the option-based ETF space, according to JPMorgan, managing just north of $44bn of assets, way out ahead of Innovator, First Trust and Global X.
Of this the biggest is by far JPMorgan Asset Management’s chunky $33bn US Equity Premium Income ETF — the largest actively managed ETF, and such a success that it has been copycatted by rivals.
And that’s not all. There’s also a trio of JPMorgan Hedged Equity Funds (mutual funds each with somewhat different reset dates) that together manage another $25.6bn. Together they are a near-$60bn whale in the US options market that other investors say they have to gingerly trade around (or seek to exploit).
Indeed, if you include option-selling mutual funds, the overall size becomes even more scary impressive. The chart below shows Nomura’s back of the envelope estimate of the combined growth in assets across select options-selling open-ended investment funds.
According to JPMorgan, this boom was driven in part by the passage of the SEC’s 2020 Derivatives Rule , which made it easier for ETF issuers who comply with new leverage and risk management requirements to sell fancy derivatives strategies.
Although the premiums harvested by these kinds of strategies can compensate investors during downturns, over the long run they don’t beat the market. That’s pretty much by design, since investors’ “potential upside is capped at the strike price plus the call premium,” said Morningstar analyst Lan Anh Tran. Basically, you give up some of the upside in return for some steady income.
The JPM analysts go on to note that the growth in option-based ETF gamma supply “has closely followed short-dated implied volatility levels (the VIX)” in recent years . . .
. . . But low volatility is great until it’s too good to be true. Of course, whether or not that is the case today seems to worry economists and journalists more than equity investors, most of whom seem to have taken the idea of higher for longer rates in their stride .
Cboe’s Mandy Xu has pushed back on the thesis that options-powered funds are driving the Vix lower , arguing that benign economic fundamentals rather than surging demand for derivative ETFs explain why markets look unusually chill right now.
To be fair, the JPMorgan team write that the growth of index overwriting strategies is a “major factor” but are not the “only reason” that volatility has become so compressed.
They’re also not too worried about these ETFs sparking another Volmageddon event, when funds selling volatility drove the Vix lower at first but “ultimately led to a volatility spike and the collapse of the short vol strategy itself” . . .
For overwriting ETFs we don’t see a similar mechanism at play that could produce a Volmageddon-type episode since the call overwriting strategies are unlevered and thus can’t have negative equity, and in case of a volatility surge during a market crash, the gamma and delta of the covered calls would quickly go to zero but wouldn’t reinforce the market move (i.e., gamma won’t turn negative). That said, once the strategies’ delta goes to ~1 (i.e., call delta to zero), dealers would no longer be suppressing volatility / buying on the move lower via their long gamma hedging. And as we note from Figure 10 below, it would take just a ~5-10% quick sell-off for that to happen at the moment.
In other words, in case of a significant market sell-off, the volatility suppressing force from these strategies is likely to disappear, leaving markets more vulnerable to other selling flows (e.g., from volatility targeting funds, CTAs/momentum investors, short gamma flows from hedging puts and levered ETFs, discretionary investors, etc.)
So that’s all right then.