IMF warns volatility products loom as next big market shock

Assets invested in such strategies estimated to have risen to about $500bn

The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets.

In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.

“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” he said

Equity market volatility has plumbed to its lowest level in a decade, with the Chicago Board Options Exchange’s implied volatility index, also known as the Vix, sitting at a level close to 10 compared with an historical average of about 20.

The IMF believes that sustained low volatility increases incentives for investors to take on higher levels of leverage while causing risk models that use volatility as an important input to understate real levels of risk participants may be taking on.

“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,” Mr Adrian said.

Mr Adrian’s warning comes amid increasing evidence that pension funds and insurance companies are venturing into riskier types of investments to gain income. Some are also effectively writing insurance contracts against a market crash to pocket premiums.

Last year the $14bn Hawaii Employees Retirement System said it was writing put options to boost its income, while other US pension schemes such as the South Carolina Retirement System Investment Commission and Illinois State Universities Retirement System have also hired outside managers to use option writing strategies.

The IMF estimates that assets invested in volatility targeting strategies have risen to about $500bn, with this amount increasing by more than half over the past three years.

Marko Kolanovic, head of macro, derivative and quantitative Strategies at JPMorgan, last month warned of “strategies that sell on ‘autopilot’”, and how risk management models that use volatility could be luring investors into taking on too much risk. “Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” he wrote in a note to clients.

With equity implied volatility continuing to drop over the course of this year investors who have bet that markets will remain tranquil have been rewarded. Yet the true quantity of complex products being sold that are linked to volatility of various assets is hard to ascertain due to such deals mostly being done in private. Regulators therefore find it difficult to map out the risks in the event of an unexpected market shock.