By Saqib Iqbal Ahmed
NEW YORK (Reuters) - Judging by the way hedge funds have been betting on Wall Street, they see U.S. stock market volatility remaining low, but it may not be that simple.
CBOE Volatility Index (VIX) futures contracts allow a play on implied volatility in stock prices and can provide a hedge on equity returns, but big speculators are currently net short 114,088 contracts in VIX futures, just under the record level set earlier this month, according to U.S. Commodity Futures Trading Commission positioning data through August 16.
After trading in a range for most of the past year, U.S. stock prices recently broke out to record highs and hedge funds have reluctantly bought into the rally. Their net long/short exposure has increased to 22.8 percent, a top quartile level, but still shy of the 5-year peak of 24.5 percent set last December, according to Credit Suisse data.
On the face of it, the CFTC data could be seen as evidence that speculators strongly believe in the lasting power of the recent rally in equities and expect the CBOE Volatility Index (.VIX), which is near historic lows, will remain subdued.
"That's not exactly right," said Maneesh Deshpande, head of equity derivatives strategy at Barclays.
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.
With the S&P 500 stock index (.SPX) near a record high, demand for these is quite strong.
For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX.P), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.
"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.
Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.
It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
THIRST FOR PROTECTION
Over the last month and a half, as stocks rallied, investors have been loading up on ETPs that profit from a jump in volatility. Roughly $1.73 billion has poured into long VIX ETPs since the start of July, according to Deutsche's Fishman.