SVOL - SVOL: Market Risk Perception Too Low Compared To Economic Reality

2023-07-12 17:01:52 ET

Summary

• The Simplify Volatility Premium ETF has seen its total assets under management triple this year to over $300M as investors clamor over ultra-high yield funds.
• SVOL is a short volatility fund that acts as a risk-insurance provider on the S&P 500, earning high premiums in good periods but potentially facing huge losses during significant market drawdowns.
• Despite its design to limit downside risk, SVOL could still suffer a quick loss should the VIX index rise rapidly.
• The VIX index is shallow today despite historically robust correction indications. The mismatch between market sentiment and economic reality could soon crater SVOL's value should the VIX spike.

Many investors today are interested in alternative strategies to generate a high-income return on their portfolio. Retired individual investors are particularly interested in very high-yielding funds to generate a more significant income without needing an extensive portfolio. On the one hand, many high-income ETFs using alternative strategies have performed decently in recent years. Conversely, most come with specifically high risks that can be mistaken when looking at historical or backward-looking metrics.

One notable example is "short volatility" strategy ETFs, such as the Simplify Volatility Premium ETF ( SVOL ). SVOL has seen its total assets under management triple this year to over $300M, as many investors clamor over its 17%+ distribution yield over the past year. See its AUM and recent performance compared to that of the S&P 500:

Since its inception, SVOL has had a generally similar volatility level to the S&P 500 ETF ( SPY ), with considerable outperformance during the more-volatile 2022. This track record benefited SVOL by boosting its TTM yield, but not necessarily its forward yield today.

SVOL is now one of the numerous short volatility funds that are returning to popular status following the 2018 collapse of many similar funds, an event known as "Volmageddon." Before 2018, when interest rates were much lower, and stock market performance was generally more stable, short volatility funds became extremely popular to generate a high-income return. Of course, these funds essentially act as risk-insurance providers on the S&P 500; At the same time, they earn high premiums in good (or stagnant) periods and often face huge losses during more significant market drawdowns or risk events.

When the S&P 500 volatility "VIX" index spiked in 2018, most short volatility funds lost all their value in a matter of days and were forced to close. Few short volatility funds existed from 2018 to 2021, but following the launch of SVOL, numerous new "short volatility" funds have seen their popularity rebound. Market conditions are similar to 2018 in that the VIX index is now shallow, meaning lower premiums will be found on short volatility ETFs today. Further, should the stock market experience a rise in volatility, it is possible that SVOL and its peers could suffer a repeat of 2018 conditions, losing a great deal of value very quickly.

Importantly, SVOL is designed very differently than its earlier peers, which were far more aggressive. SVOL has a smaller short position in VIX futures (~20% of assets) and owns OTM call options, offering it some protection against a massive spike in the VIX index. That said, I believe investors should still take a closer look at SVOL to understand the fund more clearly, as complex income ETFs can often attract investors who would not necessarily have an appropriate risk tolerance for the fund.

Understanding SVOL's Risk Profile

I believe SVOL's strategy is best understood by comparing it to providing insurance. In most periods, those being good times, OK times, or even moderately poor times, insurance providers can expect to earn a higher premium than they will pay. However, in an unexpected shock or "black swan" event, they pay out far more than they earn monthly, usually hoping to have saved enough from premiums to foot the bill. More specifically, SVOL is like an insurance provider with "reinsurance," meaning it should never lose all of its value, as many of its predecessors in 2018, because it owns VIX options that limit its downside risk. However, that does not make SVOL an inherently low-risk fund nor guarantee it will continue to outperform the S&P 500.

For one, SVOL is a far better option when the VIX index is consistently elevated. For example, in 2022, when rising interest rates began to create strains on the stock market, the VIX index was consistently hovering around the 20-30 range. In 2022, SVOL's total returns were roughly 20% above the S&P 500 due to the high VIX premiums. Since 2023 began, the VIX has moderated to the <20 range, leading to no net outperformance compared to the S&P 500. Crucially , this factor means SVOL's current yield is far below its past twelve-month distribution yield of 17%. In other words, investors will not receive a 17%+ distribution yield today unless the VIX index rises soon (which would cause SVOL to lose value). See the relationship between SVOL, VIX, and SVOL outperformance ratio to the S&P 500 below:

Today, SVOL's annualized premium on its short VIX position is likely closer to 7-11% (based on its 20% weighting and the current VIX term structure ), though it fluctuates with the VIX index. SVOL's potential yield today is about as low as possible since the VIX index is near its historical minimum level. In late 2017, the VIX index had temporarily been below 10 for some time but rose to over 57 in a matter of days in early 2018, leading to the collapse of most short-volatility ETFs at that time. Further, the VIX rose to over 80 during the 2020 crash, though over a longer timeframe. SVOL's primary risk is not a prolonged elevation in the VIX but a quick and significant increase, such as in 2018 and 2020. Thus far, it has not experienced such an event.

Fortunately, SVOL currently owns VIX call options at 50, so it should not suffer losses beyond a VIX rise over 50. Significantly, the ETF provider determines its call option hedge position and is prone to change, so there are no guarantees it will remain hedged at a VIX of 50. Importantly, SVOL's hedge is more of a hedge for the fund provider than it is for ETF owners; these call options limit SVOL's risk of total collapse in a VIX spike event, but could still quickly leave SVOL owners suffering a quick (days or weeks) 50%+ loss should the VIX quickly rise from its current level to 45+, which has happened before.

A Game of Perception and Reality

The "VIX" is often seen as a stock market risk measure. The "implied volatility" on S&P 500 options is a proxy for premium costs. More effectively, it is a gauge of market risk perception , and often perception fails to match reality. In certain circumstances, low-risk perception can cause elevated genuine risk because more significant crashes can often occur when least expected.

Today, the market's risk perception is relatively subdued. The "VVIX" index, or the "VIX of the VIX" index, is also low, meaning the market's perception of the risk of a significant VIX spike is generally low. That does not mean the risk is low (it was also lower in January 2018 and 2020), but SVOL is not paying a hefty premium for its hedge position. Further, the "SKEW" index is relatively high, meaning many speculators are buying out-of-the-money put options on the S&P 500. A high SKEW index implies some speculators and investors are concerned about a significant downside correction in stocks. It is a paradoxical benefit because many are protected against a downside stock market move, often limiting the need for a "fire sale" scenario that leads to a substantial temporary VIX spike. See the data below:

In mid-2021, when the stock market was performing very well, the SKEW index was also relatively elevated, so many market participants were hedging against a significant decline. A Moderate decline occurred in 2022, but no large crash, potentially due to the risk mitigation efforts through hedging activity. That was an excellent year for SVOL in 2022, despite generally poor stock market conditions. However, in 2022, SVOL still benefited from a generally heightened VIX level partially due to COVID-related economic concerns (or resonating "fear" following the 2020 crash), which are not necessarily a direct factor today. Today, market risk perception is generally very low, which may not necessarily be wise considering economic trends.

The yield curve is currently flirting around a record inversion level, while the manufacturing PMI is in an extreme "contraction" territory. Crude oil prices (a strong future inflation gauge) have declined with the general slowdown in manufacturing strength but have gathered ample support around $70. See below:

The stock market reacted well to the low inflation print on Wednesday morning; however, I believe it strongly indicates that the economy is slowing faster than most expect, particularly in manufacturing . The inverted yield curve and low PMI are strong leading recession indicators; however, the yield curve usually inverts 6-24 months before the onset of a recession, with the curve usually steepening quickly during recessions. Thus, the yield curve's re-steepening (from an inverted level) is likely the stronger indicator of a stock market crash associated with a recession.

For example, the yield curve and VIX "risk index" were shallow in 2007, before the S&P 500 crash. However, as the curve began to re-steepen, the VIX index began to spike as the S&P 500 suffered a recessionary crash. See below:

By this measure, the stock market's position today could be pretty similar to that of 2007. The curve is inverted, and numerous leading indicators suggest an impending slowdown. However, the market is generally complacent, and risk perception is low. Indeed, I expect a stock market crash could only occur immediately following a period of complacency and low-risk perception, as those conditions set the scene for a crash or correction (overvaluation, excessive investor expectations, FOMO, etc.). Indeed, the famous "Fear and Greed" index is in the "extreme greed" level today, with the highest "greed" level since 2021 . Overall, I believe these figures indicate a distinct possibility that SVOL could face a highly adverse risk event over the coming weeks or months based on the seemingly high mismatch between stock market sentiment and fundamental reality.

The Bottom Line

Overall, SVOL is an interesting fund that offers rewards and risks in the current environment. Importantly, as a short volatility ETF, SVOL is a relatively complex ETF, and its volatility level can change from relatively low to very high over a short timeframe. Fundamentally, it is more risky than the S&P 500 as it would likely decline by much more in the event of a quick stock market crash. However, a more prolonged bear market (such as in 2022) would not negatively impact the fund as much as the S&P 500 and could lead to net positive returns.

Further, in the current environment where risk perception is generally low (aside from the SKEW index), and the economic risk appears relatively high, I believe SVOL is more likely to offer low returns while having a fair probability of suffering an outsized loss. I believe a strong potential negative catalyst would be a "steepening" of the yield curve that often coincides with large quicker stock market drawdowns. For that reason, I am bearish on SVOL today.

Lastly, many retired-income investors looking for a stable income yield with principal protection should avoid SVOL. While SVOL's twelve-month returns are high, its forward returns will be much lower due to the compression of the VIX index. As the VIX index is unstable, so is SVOL's premium income. Additionally, its "true" SEC yield is only around 2.8%, not 17%+ , because returns from futures roll yields are not actual "dividends." In reality, SVOL is like an insurance provider, so it is expected to save its premiums in good times to have sufficient capital for negative periods. Investors who do not reinvest or save returns from SVOL will likely see their initial investment decay over time.

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