LONDON/NEW YORK, Feb 8 (Reuters) - As world markets catch their breath after a week of turmoil, investors are concerned that a new era of heightened volatility could eventually lead to a second wave of selling as investment strategies popular for years are forced to unwind.
U.S. stocks plunged nearly 8 percent in three trading days until Tuesday as an explosion in implied volatility readings prompted investors to dump equities on growing anxiety about overheating economies, inflation and rising borrowing rates.
The epicentre of the selloff was in the highly leveraged world of exchange-traded funds and related products, where investors had successfully bet for years on market volatility remaining extraordinarily low for long periods.
These complex products hinged on being 'short' on volatility futures such as the CBOE's Vix gauge of one-month implied volatility - betting on low volatility, in other words.
When the Vix shot up over two turbulent trading days, however, these trades faced a near total wipeout, triggering reversals, a further huge spike in volatility and then some of the biggest one-day falls in U.S. and world equities in years.
Although the washout was violent, it was extremely quick, and stock markets have bounced more than 5 percent off Tuesday's lows.
Nevertheless, volatility gauges remain at more than twice the previous year's average.
If they don't retreat further soon, analysts fear another wave of selling in the weeks ahead.
Highly leveraged yield-seeking strategies in high yield bonds or commodity-linked currencies that have mushroomed in the aftermath of the 2008 global financial crisis are likely to come under pressure the longer volatility stays high.
"If vol (implied volatility) stays between 20 and 30 for a protracted period of time, some of the existing volatility-targeting strategies would have to de-risk," said Vineer Bhansali, chief investment officer at California-based investment adviser LongTail Alpha, a firm that runs tail-risk strategies using options and other types of derivatives.
"But the path from here to that point is likely to be somewhat disorderly."
While markets have focused on leveraged exchange-traded notes as a guide to how large these bets are -- Morgan Stanley strategists estimate these products lost about $3.4 billion in the selloff -- investors believe the scale may be far bigger.
At the height of its popularity last month, Credit Suisse's 'inverse VIX' note, the second-biggest publicly traded product tracking the VIX, had $1.8 billion of assets, according to Thomson Reuters data.
But thanks to years of generally low volatility, in part due to money printing and bond-buying policies pursued by the world's major central banks, investors have shovelled billions of dollars into so-called 'carry trades' that often depend on financial calm persisting for long periods.
These trades typically involve borrowing in near zero interest rate currencies to invest in high yield bonds and notes in emerging markets or junk-rating companies - and praying there's no sudden foreign currency spike to wipe out accumulated profits.
But the risk of the latter grows the longer financial volatility measures stay high.
Though estimates of how much money is actually parked in such strategies are hard to come by given a general lack of transparency, some broad numbers exist.
A November paper by Bhansali and Lawrence Harris, a professor at USC Marshall School of Business, estimated that total assets under management in volatility-contingent strategies is about $1.5 trillion, including implicit volatility sellers such as risk parity funds, volatility targeting funds, risk premium harvesting funds and trend followers.
AQR, a hedge fund, says that so-called risk parity strategies alone hold about $70 billion in global equities.
Those strategies of selling volatility and buying risky assets have proved to be tremendously profitable in recent years.
The VIX has drifted lower since early 2016, staying at depressed levels below its 20-year average for nearly two years with spikes only a handful of times in the last decade.
But this week's brief spike above 50 and its subsequent partial retracement to below 30, more than double its trading range last year, has turned the spotlight on such strategies.
UBS analysts estimate that a U.S. equity decline of 7.4 percent, as seen over the last five working days, has historically been associated with a high yield spread widening of 75-80 basis points while the actual move has only been 21 basis points.
That spread is likely to adjust higher as funds who have become very comfortable in selling volatility in recent years take a more cautious view.
Davide Silvestrini, EMEA Head of global quantitative and derivatives strategy at JP Morgan, said the sharp losses experienced by short vol strategies will likely lead to reduced volatility selling flows from institutional investors.
"Not only do we expect volatility to increase in 2018, and would urge investors to remain cautious of leveraging positions too far, but we also anticipate that markets will retain the effects of volatility shocks more deeply in their collective conscience," said Eoin Murray, head of investments at Hermes Investment Management, which controls 31 billion pounds of assets.
Though market volatility has come back down significantly, a global head of equity trading strategy at a bank in London said many bank desks who are holding long volatility bets thanks to funds who have had to exit their positions are "comfortable holding them as they expect volatility to remain high."
And that has large implications for other asset classes, namely fixed income and currencies where low volatility has been a principal driver of large returns. Indeed, three month implied volatility for the euro this week is well below 2017 highs.
Hans Redeker, global head of currency strategy at Morgan Stanley in London said though the initial focus of these funds have been in the U.S, commodity-linked currencies such as the Australian dollar and the Canadian currency which have been the focus of global macro funds will come under pressure thanks to worsening fundamentals.
"I am a bit surprised that we haven't seen the contagion effect on other markets and that makes me wary about the outlook in the near term," said Morgan Stanley's Redeker.
(Additional reporting by Simon Jessop in LONDON; Graphics by Ritvik Carvalho; Editing by Mike Dolan and Hugh Lawson)