VARIANTPERCEPTION UNDERSTANDING

November 2016

Volatility and
forest fires
Contents Central bank suppression of volatility is like trying to prevent forest fires by
3 The death and resurrection
indiscriminately putting out all fires no matter how small. Although in the short-run
of volatility there are no big fires, this often leads to denser trees and debris in many forests,
7 Structural drivers of which enables unusually large wildfires to burn.
volatility
7 Structural drivers of
volatility: the credit cycle In this report, we show graphically the dampening impact of central banks and short
9 Structural drivers of volatility strategies on financial markets. While the effects of volatility compression
volatility: the economic cycle
have been clear, we believe the underlying mechanisms by which volatility is
12 The chase for yield: We’re
all vol sellers now generated have not been changed.
16 Tactical drivers of volatility:
the VP Correction Signal and
global liquidity
We update and revisit our volatility framework, which we first described in our August
18 When bad news is priced 2014 thematic report “Understanding Volatility”. Our structural volatility framework
into markets continues to focus on leading indicators of the credit and economic cycle. Our
tactical volatility framework incorporates fund flows, positioning and the volatility
yield.

It is extremely important to point out that low volatility in and of itself is not a problem.
Volatility is serially correlated, and periods of low volatility follow periods of low
volatility. Likewise periods of high volatility follow periods of high volatility. This is
very much like one of the most basic methods of weather prediction. The rule that
tomorrow’s weather will be like today’s is generally right. It is only wrong when the
weather changes. In this report we outline the tools we use to identify the changing
winds of volatility.

MACRO THEMES
> The best long-term predictor of volatility is the credit cycle. Surges in
corporate leverage often lead to volatility as the credit cycle matures. The lagged
growth in corporate credit, the shape of the yield curve and real lending rates
together reliably predict volatility regime shifts.
VARIANTPERCEPTION UNDERSTANDING

> The second big structural driver of market volatility is economic volatility.
Periods of high market volatility have generally been correlated with periods of
high economic volatility. This is true in general, but it is particularly true during
recessions when we see large spikes in the VIX and steep drawdowns in financial
markets.

> Herding in financial markets predicts crashes. The two best predictors we
have found for sharp market corrections or crashes are 1) rising volatility across
asset classes at the same time as widening credit spreads, money market and
interbank lending rates and 2) herding in financial markets as measured by cross-
asset class correlations.

> Changes to excess liquidity are good predictor of spikes and falls in
volatility. When there is a lot of excess liquidity, financial markets tend to do well,
but when excess liquidity contracts, markets tend to suffer.

> In a financially-repressed environment dominated by central banks, the

chase for yield forces investors to sell optionality and volatility to boost
investment yields. The structural short in volatility has been building for the past
4 years and is skewing future return distributions towards fatter tails.
 VARIANTPERCEPTION UNDERSTANDING

THE DEATH AND RESURRECTION OF VOLATILITY

Today the world remains in a low volatility regime, but volatility has rebounded slightly from
the lows seen in the summer of 2014.

Standardised Cross Asset Implied Volatility 2002-2016

(Equal-weighted average of equity vol, FX vol, fixed income vol, gold vol)
5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0
Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16
In hindsight our original August 2014 report actually marked the lows of cross-asset volatility
in this cycle. At the time we noted famous newspaper headlines proclaiming the death
of volatility as the ultimate contrarian indicator, just like the famous BusinessWeek cover
proclaiming “The Death of Equities” back in 1979.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 3 | 20

 VARIANTPERCEPTION UNDERSTANDING

We cannot deny the temporary impact central banks have had on financial markets
in helping to suppress volatility, but we do not believe central banks have altered the
mechanism in which volatility is generated. As central banks step back, volatility will return.
The charts below illustrate visually the impact of central banks on asset markets. The
charts show the distribution of S&P 500 weekly returns since 2010, broken out for the period
of QE2 and QE3. We can see very clearly that the return distribution had much smaller tails
during periods of QE than outside.

S&P 5 Day Returns 2010 - 2016 Excluding QE2 & QE3

S&P 5 Day Returns During QE2 and QE3
20% 20%

15% 15%

10% 10%

5% 5%

0% 0%

-5% -5%

-10% -10%

-15% -15%

-20% -20%

We also see a similar pattern in Europe for weekly Eurostoxx returns. Again since the start
of QE in Europe, the tails of the return distribution have become much smaller.

Eurostoxx 50 5 Day Returns During QE (Mar 2015 onwards) Eurostoxx 5 Day Returns 2010 - 2015
20% 20%

15% 15%

10% 10%

5% 5%

0% 0%

-5% -5%

-10% -10%

-15% -15%

-20% -20%

It is extremely important to point out that low volatility in and of itself is not a problem.
Volatility is serially correlated, and periods of low volatility follow periods of low volatility.
Likewise periods of high volatility follow periods of high volatility. This is very much like one
of the most basic methods of weather prediction. The rule that tomorrow’s weather will
be like today’s is generally right. It is only wrong when the weather changes. Furthermore,
prolonged periods of low volatility generally correspond with large equity rallies. The 1992-
97 rally was based on low volatility. The 2004-2007 rally happened during low volatility.
Likewise, the 2012-2015 rally has happened with low volatility. These were long stretches of
time during which volatility stayed low and stocks rose.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 4 | 20

 VARIANTPERCEPTION UNDERSTANDING

Low Volatility vs S&P Performance

2,900

2,400

1,900

1,400

900

400
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
VIX Trend Index S&P 500

What is different now and why are we worried about rising volatility? Today we are seeing
signs both of fundamental structural drivers of volatility and tactical drivers of volatility
aligning, which points to a potential regime shift towards higher volatility.

All things we discuss in this piece are just as relevant from a top-down perspective to credit
spreads. Given that equity has the lowest claim within the capital structure, drivers of equity
volatility will also naturally drive credit spreads and vice-versa.

VIX vs High Yield Spreads

80 2,000

70 1,750

60 1,500

50 1,250

40 1,000

30 750

20 500

10 250

- 0
May-05

May-06

May-07

May-08

May-09

May-10

May-11

May-12

May-13

May-14

May-15

May-16

May-17
Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16

High Yield Spreads (RHS) VIX (4wma)

We believe that forest fires offer an apt analogy to volatility today. Professor Didier Sornette
has cited comparisons of wildfires in Southern California and Baja California to show the
counter-intuitive effects of aggressive suppression of small wild fires. Southern California
has had aggressive fire suppression policies since 1900, whereas Baja California (north of
Mexico) has essentially a “let-burn strategy” with no active management.

As a result, Baja California tends to experience numerous small fires, which helps to avoid
too dense a build-up of forest, which actually prevents very large wildfires. Conversely, in
Southern California, aggressive micro-management of small fires actually resulted in growth
of dense underbrush that results in occasional very large fires.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 5 | 20

 VARIANTPERCEPTION UNDERSTANDING

[Source: https://www1.ethz.ch/ ]
Source: https://www1.ethz.ch/

Today the systematic suppression of volatility by central banks and short volatility strategies
are creating conditions that make a surge in volatility more likely. It appears that ultimately,
irrespective of timing, a forest will burn - the only question is whether it burns wildly or with
some control.

Source: news.mongabay.com/

Charts Source: Bloomberg, Macrobond and Variant Perception Page 6 | 20

 VARIANTPERCEPTION UNDERSTANDING

STRUCTURAL DRIVERS OF VOLATILITY

There are two key fundamental inputs that drive changes in volatility:

> Rising leverage / falling leverage. This is the credit cycle. Lagged increases in leverage
lead equity volatility and credit spreads by three years.

> Economic contraction / economic expansion. This is the economic cycle. Market
volatility is highly correlated with economic volatility, for example the VIX is highly correlated
to the ISM. Plunges in the ISM correspond to rises in the VIX. Recessions are always
associated with high equity volatility.

Sometimes these two cycles overlap, and sometimes they don’t. For example, there was
growth with rising corporate leverage and volatility from 1996-2000. From 2003-06 there
was growth with falling corporate leverage and volatility. Within these regimes, there are
distinct episodes of volatility spikes and falls. Let’s look at both regimes by turn.

STRUCTURAL DRIVERS OF VOLATILITY: THE CREDIT CYCLE

The best structural predictor of volatility regimes and credit spreads is the lagged growth
in corporate leverage. Credit cycles impact equity volatility and credit spreads with a three-
year lag on average. The equity of a firm is a perpetual option on the solvency of the firm.
Any increase in leverage increases liabilities and reduces or stresses shareholder equity
(Assets - Liabilities = Shareholder Equity).

Typically very large surges in lending are associated with loosening lending standards
and optimistic forecasts. It is usually very difficult for lending growth to accelerate rapidly
without loosening standards. Such credit surges typically have the seeds of their own
destruction embedded within them, because as the credit cycle matures, many of the credit
extended on the back of looser lending standards cannot be re-payed. This is why we
typically start by looking at the growth rate of lending as a leading indicator of volatility.

C&I Lending YoY (Advanced 3 years) vs VIX Index Net % Banks Tightening C&I Lending Standards
Large Firms vs Small Firms
60 30%
80%
50 20%
60%
40 10%
40%
30 0%
20%
20 -10%
0%
10 -20%
-20%
0 -30%
-40%
May-99
Feb-96
Mar-97

Jul-01

May-12

Jul-14
Apr-98

Oct-04

Feb-09
Mar-10
Apr-11

Oct-17
Nov-05
Dec-06

Nov-18
Dec-19
Jan-95

Jun-00

Aug-02
Sep-03

Jan-08

Jun-13

Aug-15
Sep-16

Jan-21

Oct-98
Oct-99
Oct-00
Oct-01
Oct-02
Oct-03
Oct-04
Oct-05
Oct-06
Oct-07
Oct-08
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
Oct-15
Oct-16

VIX, 3mma C&I Loans YoY, 3y fwd Large/Medium Firms Small Firms

Charts Source: Bloomberg, Macrobond and Variant Perception Page 7 | 20

 VARIANTPERCEPTION UNDERSTANDING

Although the average lead over history has been about three years from the credit surge
to delinquencies picking up and volatility rising, the lead time is clearly not constant and
depends on the length of the credit cycle. The average lag from the relationship has been
about 3 years as this is similar to the average duration of corporate debt issued. One caveat
in the current environment, which has had an extended period of low rates and forward
guidance, is that the average duration of debt may be higher, and thus the lag would be
slightly longer.

To help us determine when the credit cycle is maturing, we can use the real fed funds rate
and yield curves to proxy for slowing growth and rising debt service ratios. Higher real rates
correspond to higher corporate debt payments. This tends to reduce net income and eat up
more of corporate cash flow.

VIX vs Real Fed Funds Rate VIX vs VP Yield Curve Index (Advanced 3 Years)
8% 60 -1.0 60
6% 50 -0.5 50
4% 0.0
40 40
2% 0.5
30 30
0% 1.0
20 20
-2% 1.5
-4% 10 10
2.0
-6% 0 2.5 0
Jul-02
May-03
Mar-04

Jul-07
May-08
Mar-09

Jul-12
May-13
Mar-14

Jul-17
May-18
Mar-19
Nov-00

Nov-05

Nov-10

Nov-15
Jan-00

Sep-01

Jan-05

Sep-06

Jan-10

Sep-11

Jan-15

Sep-16

Jan-20

Jul-02
May-03
Mar-04

Jul-07
May-08
Mar-09

Jul-12
May-13
Mar-14

Jul-17
May-18
Mar-19
Nov-00

Nov-05

Nov-10

Nov-15
Jan-00

Sep-01

Jan-05

Sep-06

Jan-10

Sep-11

Jan-15

Sep-16

Jan-20
Real Feds Fund Rate, 24m fwd Vix, 3mma VP Yield Curve Index, inverted, 36m fwd VIX, 3mma

We can see that the real fed funds rate gives a good 2 year lead on volatility, while the
inverted yield curve (a proxy for future economic growth) gives a good 3 year lead. The VP
Yield Curve Index looks at all maturities and not just very short vs very long yields.

As slowing growth and rising debt service costs start to feed into company cash flow
statements, we would expect equity, with the lowest claim on company assets, to experience
the most stress. We can see this in the left chart below, where falling corporate cashflows
relative to debt outstanding leads volatility higher by about a year. The corporate financing
gap, which is a proxy for the difference between capital expenditures and internal funds, also
offers a 9 month lead on volatility, again showing that when companies experience cashflow
problems relative to their capex needs, the equity will come under pressure.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 8 | 20

 VARIANTPERCEPTION UNDERSTANDING

US Corporate Cashflows / Debt (Advanced 1 Year)

vs High Yield Spreads
US Corp Financing Gap / GDP (Advanced 9 Months)
1,800 15% vs VIX Volatility Inex
1,600 -15% 50
20% 45
1,400
-10% 40
1,200 35
25% -5%
1,000 30
25
800 0%
30% 20
600
5% 15
400 35% 10
200 10% 5

Mar-90

Mar-93

Mar-96

Mar-99

Mar-02

Mar-05

Mar-08

Mar-11

Mar-14

Mar-17
Sep-91

Sep-94

Sep-97

Sep-00

Sep-03

Sep-06

Sep-09

Sep-12

Sep-15
0 40%
Mar-00

Mar-03

Mar-06

Mar-09

Mar-12

Mar-15
Sep-98

Dec-00

Dec-03

Dec-06

Dec-09

Dec-12

Dec-15
Jun-99

Sep-01
Jun-02

Sep-04
Jun-05

Sep-07
Jun-08

Sep-10
Jun-11

Sep-13
Jun-14

Sep-16
Jun-17
US Corporate Financing Gap / Nominal GDP (Advanced 1 Year)
Credit Suisse HY index US Corp Cashflow/Debt (Advanced 1 Year) Inverted VIX Volatility Index

Ultimately as charge-off rates and defaults pick up, we will see spikes in volatility.

Commercial & Industrial Loans Charge Off Rates

vs Equity Volatility
3.0% 50
45
2.5%
40
2.0%
35
1.5% 30
25
1.0%
20
0.5%
15
0.0% 10
May-12
Feb-96
Mar-97

May-99

Jul-01

Jul-14
Apr-98

Oct-04

Feb-09
Mar-10
Apr-11
Dec-93

Nov-05
Dec-06
Jan-95

Jun-00

Aug-02
Sep-03

Jan-08

Jun-13

Aug-15
Sep-16

US C&I Charge Off Rates VIX

STRUCTURAL DRIVERS OF VOLATILITY: THE ECONOMIC

CYCLE

The second big driver of market volatility is economic volatility. Periods of high market
volatility have generally been correlated with periods of high economic volatility.

Market Volatility and Economic Volatility

14% 40%

12% 35%
30%
10%
25%
8%
20%
6%
15%
4%
10%
2% 5%
0% 0%
Jan-74
Jan-76
Jan-78
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
Jan-16

Economic Volatility (LEI 12m Standard Deviation)

Market Volatility (S&P 500 12m Standard Deviaton)

Charts Source: Bloomberg, Macrobond and Variant Perception Page 9 | 20

 VARIANTPERCEPTION UNDERSTANDING

This is true in general, but it is particularly true during recessions when we see large spikes
in the VIX and steep drawdowns in financial markets.

Recession Stories and VIX VP Recession Signal

and Recessions Stories
20,000 70 20,000
18,000
60
16,000 16,000
14,000 50
12,000 12,000
40
10,000
8,000 30 8,000
6,000 20
4,000
4,000
10
2,000
0
0 0

Sep-96
Sep-97
Sep-98
Sep-99
Sep-00
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
Sep-96
Sep-97
Sep-98
Sep-99
Sep-00
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Sep-12
Sep-13
Sep-14
Sep-15
NBER Recessions Recession Stories (BBG)
Recession Stories (BBG) VIX VP Recession Model (rescaled)

We can see that volatility tracks the prevalence of news stories about recessions. The VP
Recession Model, reassuringly, provides a good lead on recessions and spikes in recession
stories, which should help us to warn clients about imminent recessions and big spikes in
volatility.

At Variant Perception we focus on leading economic indicators because they tell us about
the future rather than about the past. Leading economic indicators are most closely aligned
with changes to conditions in the financial markets.

Our leading indicator for the US economy (published monthly in our Leading Indicator
Watch) provides a 6 month lead on US growth. As the left chart below shows, the indicator
also gives a good 6 months lead on charge-off rates, which are expected to rise over the
next 6 months. Similarly the right hand chart shows the VP Stress Index, which looks for
signs of stress across leading indicators for different sectors of the US economy. This also
gives a good 12 month lead on charge off rates.

VP US Short-leading (Advanced 6 Months, inverted) C&I Charge Off Rates vs VP Stress Index (Advanced 12 months)
vs C&I Charge-Off Rates 70 3.0%
-10% 3.0%
-8% 60 2.5%
2.5%
-6%
50
-4% 2.0% 2.0%
-2% 40
1.5% 1.5%
0%
30
2% 1.0%
1.0%
4% 20
0.5%
6%
10 0.5%
8% 0.0%
Dec-89

Dec-91

Dec-93

Dec-95

Dec-97

Dec-99

Dec-01

Dec-03

Dec-05

Dec-07

Dec-09

Dec-11

Dec-13

Dec-15

0 0.0%
Feb-90
Mar-91

May-93

Jul-95

May-06

Jul-08
Apr-92

Oct-98

Feb-03
Mar-04
Apr-05

Oct-11

Feb-16
Mar-17
Dec-87

Nov-99
Dec-00

Nov-12
Dec-13
Jan-89

Jun-94

Aug-96
Sep-97

Jan-02

Jun-07

Aug-09
Sep-10

Jan-15

VP US Short Leading Indicator (6 months forward)

C&I Loans Charge-off Rate VP Stress Index (12 months forward) C&I Charge Off Rates

This insight is further confirmed if you look at the VIX vs the ISM. Falls in industrial
production are highly correlated to changes in volatility. This is particularly true when

Charts Source: Bloomberg, Macrobond and Variant Perception Page 10 | 20

 VARIANTPERCEPTION UNDERSTANDING

declines in economic activity follow periods of high corporate leverage.

VIX vs ISM (Inverted) VIX vs ISM Implied VIX

30 60 60

35 50 50

40
40 40
45
30 30
50
20 20
55

60 10 10

65 0 0
Feb-96
Feb-97
Feb-98
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10
Feb-11
Feb-12
Feb-13
Feb-14
Feb-15
Feb-16
Feb-17

Aug-95

Aug-96

Aug-97

Aug-98

Aug-99

Aug-00

Aug-01

Aug-02

Aug-03

Aug-04

Aug-05

Aug-06

Aug-07

Aug-08

Aug-09

Aug-10

Aug-11

Aug-12

Aug-13

Aug-14

Aug-15

Aug-16
VIX, 3mma (RHS) ISM (LHS) VIX, 3mma (RHS) Implied VIX

Volatility tends to move from regimes of low volatility to regimes of high volatility and
back. The shift from one regime to another is driven by increases or decreases in
corporate leverage and the economic cycle.

All structural indicators we look at are pointing to higher volatility ahead and shift in
volatility regime. So why have we not seen more volatility so far?

So far in this cycle, historically reliable relationships between fundamental economic data
and volatility are diverging. As you can see below, volatility has remained much lower than
anticipated by our fundamental indicators.

VIX Volatility Index vs

VP Volatility Leading Index (Advanced 3 Years)
30% 60

20% 50
10%
40
0%
30
-10%
20
-20%

-30% 10

-40% 0
Jul-02
May-03
Mar-04

Jul-07
May-08
Mar-09

Jul-12
May-13
Mar-14

Jul-17
May-18
Mar-19
Nov-00

Nov-05

Nov-10

Nov-15
Jan-00

Sep-01

Jan-05

Sep-06

Jan-10

Sep-11

Jan-15

Sep-16

Jan-20

VP Leading Index for VIX, 36m fwd Vix, 3mma

A number of other historically reliable leading relationships between volatility and

fundamental data have also broken down in the current cycle. For example, the chart below
shows the Kalecki decomposition of profits, which historically offered a good two-year lead
on volatility. The idea being that as households and governments save more and retrench
from spending, corporate profits come under pressure, which leads to stress for companies.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 11 | 20

 VARIANTPERCEPTION UNDERSTANDING

Government + Household Savings (Advanced 2 Years)

vs VIX Volatility Index
60 8%
6%
50
4%
40 2%
0%
30
-2%
20 -4%
-6%
10
-8%
0 -10%
Mar-92
Mar-93
Mar-94
Mar-95
Mar-96
Mar-97
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
Mar-15
Mar-16
Mar-17
Mar-18
VIX (3m MA)
Government + Household Saving (3y Change, % of GDP, 2y fwd)

We would also point out that the average maturity of debt (we use C&I loans as a proxy) has
risen in this cycle, facilitated by ultra-accommodative central banks. If the average maturity
of debt has risen, then the length of time between loans being extended and the corporate
stress and volatility associated with repayment and renewal may also have risen.

We believe that changes in market structure help to explain the divergence of volatility
from fundamental data. For all the reasons laid out above, we do not believe that the
mechanisms by which volatility is generated have fundamentally changed. Central
banks can elongate and affect the credit cycle and the economic cycle, but they cannot
fundamentally alter how economic agents function in a market economy.

In the next section, we review changes in market structure that we believe are the main
reasons for why volatility has remained low relative to fundamental indicators.

THE CHASE FOR YIELD: WE’RE ALL VOL SELLERS NOW

The legacy of this cycle will be central-bank intervention and balance-sheet expansion.
As we discussed in our Feb 2015 thematic report “Understanding QE”, a key channel through
which QE works is the portfolio rebalancing channel. By reducing the availability of “risk-
free” assets, central banks force investors further along the risk and duration curves,
lowering the risk premiums embedded in asset prices.

This makes selling volatility an attractive option to get yield. As the chart below shows, the
implied yield from selling out of the money put options on the S&P 500 for 1yr offers very
attractive returns relative to similar duration options in the fixed income markets. As we
showed on page 4, central banks have also had a significant impact on market volatility
by suppressing the fat tails in the market, making it even more attractive to sell tail risk
protection to pick up yield.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 12 | 20

 VARIANTPERCEPTION UNDERSTANDING

Yield from selling volatility vs Fixed income yield

10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%

Jul-07

May-08
Apr-06

Feb-07

Oct-08
Mar-09

Apr-11

Feb-12
Jul-12

May-13
Oct-13
Mar-14

Apr-16

Feb-17
Nov-05

Dec-07

Nov-10

Dec-12
Jun-05

Sep-06

Aug-09
Jan-10
Jun-10

Sep-11

Aug-14

Nov-15
Jan-15
Jun-15

Sep-16
1y T-Bills US High Yield US Corporate 1-3 Yr S&P 500 Volatility Yield (1yr 80% OTM Put/Notional)

Since the financial crisis, it has generally worked out well for investors to aggressively sell
spikes in volatility to capture extra yield. The chart below on the right shows that short
volatility strategies have outperformed tail-risk hedging and long volatility strategies since
2010. Spikes in VIX have been contained as short volatility strategies act as a natural
mechanism to suppress volatility.

Hedge Fund Volatility Strategies Short Volatility Strategies vs VIX

150 150 50
140 45
130 140 40
120 130 35
110 30
100 120 25
20
90 110 15
80
100 10
70 5
60 90 0
Oct-10
Feb-11

Oct-11
Feb-12

Oct-12
Feb-13

Oct-13
Feb-14

Oct-14
Feb-15

Oct-15
Feb-16

Oct-16
Feb-17
Jun-10

Jun-11

Jun-12

Jun-13

Jun-14

Jun-15

Jun-16

Oct-10
Feb-11

Oct-11
Feb-12

Oct-12
Feb-13

Oct-13
Feb-14

Oct-14
Feb-15

Oct-15
Feb-16

Oct-16
Feb-17
Jun-10

Jun-11

Jun-12

Jun-13

Jun-14

Jun-15

Jun-16
CBOE Long Vol Hedge Fund Index CBOE Tail Risk Hedge Fund Index
CBOE Short Vol Hedge Fund Index CBOE Short Vol Hedge Fund Index VIX

The next chart shows that writing puts has been one of the more common ways of trying to
generate alpha since the crisis. The CBOE put-writing index has a correlation to the HFRX
hedge fund aggregate index of above 95%. Correlation is of course not causation, but this
has been a well-known strategy for hedge funds.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 13 | 20

 VARIANTPERCEPTION UNDERSTANDING

Aggregate Hedge Fund Performance vs Selling Puts

(95.8% Correlation)
180
170
160
150
140
130
120
110
100
90
80

Oct-10
Feb-11

Oct-11
Feb-12

Oct-12
Feb-13

Oct-13
Feb-14

Oct-14
Feb-15

Oct-15
Feb-16

Oct-16
Feb-17
Jun-10

Jun-11

Jun-12

Jun-13

Jun-14

Jun-15

Jun-16
CBOE S&P 500 PutWrite Index HFRX Aggregate Index

Another key trend since the crisis has been the increasing popularity of VIX futures. The
explosion in VIX futures open interest has been driven in part by the rising AUM of volatility
based ETFs, which are trading instruments rather than buy-and-hold instruments.

VIX Futures Total Open Interest Total Assets Under Management for Volatility ETFs
700,000 6,000

600,000 5,000

500,000 4,000

400,000 3,000

300,000 2,000

200,000
1,000
100,000
0
Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Oct-11

Apr-12

Oct-12

Apr-13

Oct-13

Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16
Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17
0
Jul-05
Feb-06

Mar-10

May-11

Jul-12
Apr-07

Oct-10

Feb-13

Apr-14
Dec-04

Nov-07

Dec-11

Nov-14
Sep-06

Jun-08
Jan-09
Aug-09

Sep-13

Jun-15
Jan-16
Aug-16

Long Vol ETFs Levered Long Vol ETFs Short Vol ETFs

We can convert the AUM of these ETFs into a USD vega equivalent after adjusting for
leverage and short interest. As we can see from the left chart below, the vega from these
ETFs is often worth 30-40% of the entire open interest in the futures market, making them a
very significant driver of volatility at present. The right chart shows the impact of the ETFs
on the VIX futures term structure. ETFs have to constantly roll their VIX futures positions
from the front month to the second month (the two most liquid contracts). Therefore, when
ETFs are very long volatility, they exert steepening pressure on the VIX futures curve, as they
keep selling the front month contracts to buy the next month ones. Similarly when the ETFs
are net short volatility, they exert flattening pressure.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 14 | 20

 VARIANTPERCEPTION UNDERSTANDING

Net Equivalent USD Vega Notional Exposure of Volatility ETFs Bns as % of Net Equivalent USD Vega Notional Exposure of Volatility ETFs Bns
Total VIX Futures Open Interest (XIV, SVXY, VXX, TVIX, UVXY, VIXY, ZIV) vs 2m/1m VIX Futures Premium
(XIV, SVXY, VXX, TVIX, UVXY, VIXY, ZIV)
50% 200 20%
40% 15%
150
30%
10%
20% 100
5%
10% 50
0% 0%
0
-10% -5%
-20% -50
-10%
-30% -100 -15%
-40%
-150 -20%
-50%

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Oct-11

Apr-12

Oct-12

Apr-13

Oct-13

Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16
Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17
Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Oct-11

Apr-12

Oct-12

Apr-13

Oct-13

Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16
Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17
As percentage of VIX Futures Open Interest Net Equivalent USD Vega Notional Exposure ETFs 2m/1m VIX Futures Premium

We can see that ETF activity has had a suppressive effect on volatility in general. Although
ETF investors tend to be generally long volatility, any spikes in volatility are treated as
opportunities to get short. We can see how quickly net positioning flips from long to short
during the vol spikes in summer 2011, end of 2014 and summer 2015. We believe this
reflects the wider mentality of selling volatility to pick up extra yield that we discussed above
in this section.

Net Equivalent USD Vega Notional Exposure of Volatility ETFs Bns vs VIX
(XIV, SVXY, VXX, TVIX, UVXY, VIXY, ZIV)
200 50
45
150
40
100 35

50 30
25
0 20
-50 15
10
-100
5
-150 0
Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Oct-11

Apr-12

Oct-12

Apr-13

Oct-13

Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16
Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Net Equivalent USD Vega Notional Exposure ETFs VIX

Reviewing the speculative net positioning of VIX futures using the commitment of traders
report, we can see that in vega terms, speculative short positioning reached an all-time low
back in September. Although this has eased a little, overall speculators still remain very
short volatility.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 15 | 20

 VARIANTPERCEPTION UNDERSTANDING

VIX vs Vega USD Notional Implied by Net Speculative Position

(assume 1,000 USD vega per contract)
60 50

40
45
20
40
0

-20 35
-40
30
-60

-80 25

-100
20
-120
15
-140

-160 10
Mar-09

Mar-10

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16
Sep-09

Sep-10

Sep-11

Sep-12

Sep-13

Sep-14

Sep-15

Sep-16
Net Speculative Vega Notional, mn USD (LHS) VIX Future (RHS)

TACTICAL DRIVERS OF VOLATILITY: THE VP CORRECTION

SIGNAL AND GLOBAL LIQUIDITY

Volatility is not an academic question, and the only reason we care about forecasting
changes to volatility regimes and specific spikes in volatility is to make money. We have
built a variety of tools at VP to predict crashes and surges in volatility. In the following
section we outline tools that we use on a daily basis.

The two best predictors we have found for crashes are 1) rising volatility across asset
classes at the same time as widening credit spreads, money market and interbank lending
rates and 2) herding in financial markets as measured by cross asset class correlations.
These tools for forecasting crashes work on a daily basis.

Since we last wrote our August 2014 report, we have simplified our original correction/
crash signal to be more robust to capturing shifts in market regimes. The idea is still the
same: to capture simultaneous stress across different asset classes.

Our correction indicator does not necessarily forecast market corrections, but it tells you
when the conditions for a correction are present. This year we have warned clients twice
of potential market corrections on January 5th before an almost 10% market sell-off and
on June 15th before Brexit.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 16 | 20

 VARIANTPERCEPTION UNDERSTANDING

Variant Perception Strong Correction Signal

2,600

2,400

2,200

2,000

1,800

1,600

1,400

1,200

1,000

800

600
Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Apr-14

Apr-15

Apr-16
Dec-07

Aug-08
Dec-08

Aug-09
Dec-09

Aug-10
Dec-10

Aug-11
Dec-11

Aug-12
Dec-12

Aug-13
Dec-13

Aug-14
Dec-14

Aug-15
Dec-15

Aug-16
Dec-16
Strong Correction S&P

Whenever the signal triggers, it offers compelling risk-reward to buy out of the money puts,
to capture both spikes in volatility as well the underlying move in the S&P 500.

Strong Correction Signal

90

80

70

60

50

40

30

20

10

0
Mar-08

Mar-09

Mar-10

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16

Mar-17
Dec-07

Sep-08
Dec-08

Dec-09

Dec-11

Dec-12

Dec-14
Jun-08

Jun-09
Sep-09

Jun-10
Sep-10
Dec-10

Jun-11
Sep-11

Jun-12
Sep-12

Jun-13
Sep-13
Dec-13

Jun-14
Sep-14

Jun-15
Sep-15
Dec-15

Jun-16
Sep-16
Dec-16

Strong Correction VIX

Investors should also be buyers of volatility when there is herding in financial markets. In the
following chart, you can see our signal for rapidly rising cross-asset class correlation. Spikes
in cross asset correlations tend to precede large rises in volatility.

Global Cross Asset Correlations vs VIX

90 55%

80

50%
70

60
45%
50

40
40%
30

20
35%

10

0 30%
Mar-04

Apr-06

Feb-07
Jul-07

May-08
Oct-08
Mar-09

Apr-11

Feb-12
Jul-12

May-13
Oct-13
Mar-14

Apr-16

Feb-17
Aug-04

Nov-05

Nov-10

Dec-12
Jan-05
Jun-05

Sep-06

Dec-07

Aug-09
Jan-10
Jun-10

Sep-11

Aug-14

Nov-15
Jan-15
Jun-15

Sep-16

VIX Global Cross Asset Correlation

Charts Source: Bloomberg, Macrobond and Variant Perception Page 17 | 20

 VARIANTPERCEPTION UNDERSTANDING

When all asset classes become correlated, this is a classic sign of herding in financial
markets. Investors all begin to imitate each other and take their cues from prices rather
than fundamentals. In this situation, most traders will attempt to sell at the same time, and
volatility will spike.

WHEN BAD NEWS IS PRICED INTO MARKETS

Volatility is serially correlated, but extreme spikes in volatility are hard to sustain. Generally
central banks react, and markets price in extremely bad news. This makes global liquidity
conditions another good predictor of spikes and falls in volatility. We can proxy global
liquidity by using money growth or excess liquidity. When there is a lot of liquidity, financial
markets tend to do well, but when liquidity contracts, markets tend to suffer.
DM Real M1 (GDP-Weighted, Local Currency) Advanced 9 Months
vs MSCI World
60% 14%
12%
40%
10%
20% 8%
6%
0%
4%
-20% 2%
0%
-40%
-2%
-60% -4%
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-12
Jun-13
Jun-14
Jun-15
Jun-16
Jun-17

MSCI World (DM) YoY, 3mma (LHS) DM Real M1 YoY, 3mma, 9m fwd (RHS)

As you can see from the chart below, rising liquidity tends to lead to lower volatility and
falling liquidity tends to lead to higher volatility.

DM Real M1 (GDP-Weighted, Local Currency) Advanced 9 Months

vs VIX Volatility Index
70 -4%
-2%
60
0%
50
2%
40 4%

30 6%
8%
20
10%
10
12%
0 14%
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-12
Jun-13
Jun-14
Jun-15
Jun-16
Jun-17

VIX (LHS) DM Real M1 YoY, inverted, 9m fwd (RHS)

Charts Source: Bloomberg, Macrobond and Variant Perception Page 18 | 20

 VARIANTPERCEPTION UNDERSTANDING

It is when markets have effectively priced in the bad news that volatility tends to collapse. At
Variant Perception, we have developed a number of tactical signals that try to capture ‘peak
panic’ in the market to generate buy signals for the market. These signals do not go off very
often and when they do, many signals tend to go off at the same time.

Volatility And Credit Post-Crash Relief Rally S&P 500 Modified Zweig Thrust Buy Signal
2,600 2,600

2,400 2,400

2,200 2,200

2,000 2,000

1,800 1,800

1,600 1,600

1,400 1,400

1,200 1,200

1,000 1,000

800 800
600 600
Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Apr-14

Apr-15

Apr-16
Dec-07

Aug-08
Dec-08

Aug-09
Dec-09

Aug-10
Dec-10

Aug-11
Dec-11

Aug-12
Dec-12

Aug-13
Dec-13

Aug-14
Dec-14

Aug-15
Dec-15

Aug-16
Dec-16

Feb-10
May-10

Feb-11
May-11

Feb-12
May-12

Feb-13
May-13

Feb-14
May-14

Feb-15
May-15

Feb-16
May-16

Feb-17
Aug-09
Nov-09

Aug-10
Nov-10

Aug-11
Nov-11

Aug-12
Nov-12

Aug-13
Nov-13

Aug-14
Nov-14

Aug-15
Nov-15

Aug-16
Nov-16
Strong Post-Crash Buy S&P Modified Zweig Thrust Buy Signal S&P 500

Charts Source: Bloomberg, Macrobond and Variant Perception Page 19 | 20

 VARIANTPERCEPTION UNDERSTANDING

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ANT PERCEPTION®. VARIANT PERCEPTION DISTRIBUTES ITS PUBLICATIONS ON A PAID SUBSCRIPTION BASIS ONLY.
© Copyright 2017 by VP Research, Inc.

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It is a violation of US federal and international copyright laws to reproduce all or part of this publication by email, xerography,
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before making any investment decisions. This report is not an offer to sell or a solicitation to buy any investment security.
Variant Perception’s reports are based on proprietary analysis and public information that is believed to be accurate, but no
representations are made concerning the accuracy of the data. The views herein are solely those of Variant Perception and are
subject to change without notice. Variant Perception’s principals may have a position in any security mentioned in this report.

All data is sourced from Bloomberg unless otherwise stated.

Charts Source: Bloomberg, Macrobond and Variant Perception Page 20 | 20