-Mark Twain (attrib.)
The term “relative value” can at times be slippery. Distinct from directional investing and arbitrage, the term is loosely defined as an investment designed to capture a contraction or expansion between the market values of two instruments that are not directly related but which share common economic drivers.
Earlier this week we purchased the Canadian dollar (FXC), in part, because of the relative value play between it and the US dollar (i.e. Canada and the US are both stable North American democratic economies that share(d) a high degree of financial integrity by international standards). The deficit driven US economy is facing the grave consequences of exploding levels of debt and slowing personal consumption, while the smaller and surplus driven Canadian economy ‘s only major negative is slowing GDP growth spurred by declining commodity prices.
The massive spikes in volatility levels this week appeared to be driven by indiscriminate buyers willing to pay up no matter what the price. Recall that on Thursday that we speculated that some of this buying was due to a large player (or players) being forced to liquidate short volatility positions rather than investors trying to hedge risk.
Market chatter has been full of speculation that several large players (including one particularly large fund based in Chicago) have been whipsawed in a “relative value” volatility transaction. Details are sketchy but my guess, based on this frenzied buying, is that the trade in question was a play on the relative level of volatility of small caps vs. large caps. Whether making a straightforward wager on the VIX vs. the RVXK (the Russell 2000 equivalent) or a more complex dispersal transaction spanning individual names –anyone who was counting on large cap equity volatility to revert to its historical low levels relative to small caps has been in a world of pain.
This brings to mind the demise of Long Term Capital. This of course occurred only a decade ago when the masters of bond arbitrage gambled on an equity volatility mean reversion with disastrous results. Then, the LTCM traders were undone when the VIX levels held out at anomalous levels for much longer than they anticipated. This time around not only have volatility levels sustained at highs for a prolonged period, the relative spread between the VIX and the RVXK has swung wildly, providing stresses that exceed any historical comparison. As such, any model based approach is suffering for lack of context.
Simply put, I saw the wild action in the VIX this week as the capitulation of hedge funds who were betting on a mean reversion, rather than a broad market capitulation signaling a bottom.