By Lu Wang
(Bloomberg) — Buying the dip. Sheltering in megacaps. Playing a Fed pivot. Things that paid off in the last equity bear market have been a ticket to the poorhouse during this one.Â
Another professional strategy that isn’t aging well is buying crash insurance — stock hedges designed to pay off in a sudden downturn, like in 2020. The trade in this year’s excruciating slog is doing little to cushion portfolios, in some cases making things worse.
___STEADY_PAYWALL___The latest example: When the S&P 500 tumbled 2.5% Wednesday on hawkish comments from Federal Reserve Chair Jerome Powell, the Cboe Volatility Index, know as the VIX, was basically flat. That means bets on higher volatility failed to deliver gains even as turbulence erupted.
Expecting history to repeat is a cognitive mistake that has claimed many an investor hide. Purchasing stock-insurance policies designed for the wrong kind of bear market is shaping up as one of this year’s bigger blunders.
Consider the Cboe S&P 500 5% Put Protection Index (PPUT). It tracks a strategy that holds a long position on the equity gauge while buying monthly 5% out-of-the-money puts as a hedge. That tactic is nursing a loss that is almost identical to the market’s, down roughly 20% — a stark contrast from the March 2020 crash, when the trade returned 2.2%.
“There is a lot of frustration about hedges underperforming or not performing on the downside,” said Brian Bost, co-head of equity derivatives in the Americas at Barclays Plc. “How can you have a year that’s arguably the worst in decades for the S&P 500 and not have spikes in vol? For a lot of investors, that’s a bit of a head scratcher.”
The speed with which the market climate changed is most of the reason. Over 10 months, stocks have morphed from a bacchanalia of day-trader exuberance to what might end up becoming the slowest downward grind in four decades, courtesy of inflation and the Federal Reserve. The transition has been a painful one for institutions and quick-trigger speculators alike.
Unlike in 2020, today’s market retrenchment has been punctuated by frequent counter-trend rallies, making this bear run the second-slowest since the 1980s, with the S&P 500 losing an average 0.09% a day. Such an orderly, slow-motion selloff meant many wagers on a market crash didn’t work.
Of course, options hedging comes in all shapes and forms, and strategies tuned to contours that allowed for a slower grind bore fruit. It’s the ones that foresaw a repeat of the Covid-19 crash that are proving a frustration.
Take another popular protective trade of buying calls on the VIX, a measure tracking prices of options tied to the equity benchmark. Since the VIX gauge typically rises when equities fall, owning upside options is often a way of defusing losses. This year, however, an S&P 500-tracking portfolio (VXTH) that adds calls on the VIX has trailed the market by roughly 7 percentage points. The tail hedge not only failed to bear fruit but created additional losses.Â
Saying exactly how much money has been poured into strategies like these is an inexact science. Several ETFs whose payout is underpinned by similar trades have been getting inflows all year despite falling as much or more than the markets they track. Investors have sent $30 million to the Simplify U.S. Equity PLUS Downside Convexity ETF (SPD), which holds a passive S&P 500 exposure with out-of-money puts and is down 25% this year.
“Something like SPD is a tail protection strategy that works when you see a very sharp selloff,” said Paul Kim, chief executive officer and co-founder at Simplify Asset Management. “I’d say it’s working as intended because we haven’t seen the follow-through and sharp selloff the strategy is designed to protect against.”
Quick reversals have been a signature feature of today’s market. The S&P 500’s 10-month bear run has come with seven rallies of at least 5%. Along the way, the index has wiped out 1% intraday gains or losses 26 times, on course for the wildest year since the 2008 financial crisis.
Ironically, volatility gauges like the VIX have been muted this time around partly because investors succeeded in one feat of foresight: seeing trouble on the horizon when inflation started proving sticky at the end of 2021. That spurred concern over Fed tightening that in turn fueled a vicious selloff in once-darling stocks, such as expensive software shares. Money managers quickly slashed equity exposure.
Everyone was prepared for another jarring market crash, and that, in essence, is why certain categories of protective options have failed to pay off this year, according to Benn Eifert, founder of QVR Advisors.
The shift is best illustrated by the sensitivity of the implied volatility — a gauge of option prices —  to the movement of underlining shares. At the end of last year, a measure tracked by QVR of the reactivity of the S&P 500’s implied vol to its returns surged to the highest level since at least 2008, a sign of elevated hedging impulse. Now, it has plunged to one of the lowest in the past decade.Â
That means fast-twitch options have been less responsive to this year’s equity rout. When shares drop, demand for fresh protection remains subdued given the unusually thin positioning among big money. At the same time, put owners quickly book profits, often leading to a drop in implied vol.
In the case of VXTH, the VIX’s subdued reaction is to blame for the trade flopping. Unlike the 2020 pandemic crisis, when the VIX soared past 80, the options gauge this time peaked near 36 in March and has since stayed below that level even the S&P 500 plumbed fresh lows.
“The people who did not do well with their hedges were people who were looking at the last crisis and trying to hedge that,” QVR’s Eifert said. “You look at the last really big bad thing and think it could happen. And usually the last bad thing that happened isn’t going to be that much like the next bad thing to happen.”Â
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