The majority of U.S. hedge funds aren't expecting another big stock market sell-off as more firms curb bets on equity volatility, according to analysis at Nomura.
Despite a deterioration in U.S.-China trade relations and a stock sell-off starting in early May and continuing through Monday, many American hedge funds have closed positions betting on a rise in the Cboe Volatility Index within the last week. Those diminished bets for volatility suggest that some of Wall Street's biggest players believe the equity decline is finally over, according to strategist Masanari Takada.
"Investors look to have locked in profits on their long VIX calls (premised on a rise in the VIX). This rollback of downside hedges may have indirectly supported the US equity rebound," wrote the Nomura quantitative strategist. "As a result, US equity exposure at hedge funds overall has turned upward again."
Stocks sold off starting May 6, the first trading day after President Donald Trump announced on Twitter that the tariff rate on $200 billion of Chinese imports would rise to 25% from 10%. Markets around the world remained on edge for much of the following week. The VIX, one of Wall Street's best fear gauges, rose above 23 on May 9 – its highest level since the start of 2019.
Retaliation from Beijing in the form of higher tariffs on U.S. goods also eroded investor confidence. A breakdown in trade negotiations left both the Dow Jones Industrial Average and the each down about 2.5% since May 3.
Exchange-traded products pegged to VIX futures rallied in tandem, with the VelocityShares Daily 2x VIX Short-Term exchange-traded note up more than 20% in the past month. The exchange-traded vehicle, which tries to double the daily return of VIX futures, raised north of $270 million in April alone and more than $900 million in 2019.
But volatility has sharply declined since the beginning of the month. A measure that tracks the call-to-put ratio for VIX options — that is, the percentage of people betting on a rise versus a fall in volatility— has since returned to lows not seen for months. That could mean that indexes may have seen the worst of their springtime woes as hedge funds take on more stock exposure, Takada told clients.
"The majority of hedge funds, cautious of the risk of a correction in the US market, seem to have intentionally held down their exposure to US stocks in April. But they also seem to have cleared away their downside hedge positions," Takada added. "Of course, this also means hedge funds have left themselves defenseless in the event of another sharp drop in US stocks."
Still, "it would appear that the majority of hedge funds do not expect another sharp rise in volatility, and that they have concluded that the correction has run its course," he added.