Like a pendulum that swings back and forth, investor sentiment oscillates between extreme greed and fear. Nothing can express such sentiment more than the concept of volatility, which is simply the mismatch between expectation and reality. As reality often diverges from expectations, or as greed and fear overcome market sentiment, volatility can explode higher, either in the form of an overly-speculative bull market rally, or in the form of an extreme market downturn. On the flip-side, volatility can shrink, either very quickly when reality misses extreme bullish or bearish expectations, or slowly, typically when markets grind slowly higher. In this constant battle between these two extreme emotions, we have witnessed a full cycle of volatility in 2020. Now as volatility has normalized and set to enter a new cycle, it would be prudent to have a review of the Hong Kong volatility markets, the structural changes observed, and the overall opportunities as a whole.
Where are we at in the Volatility Cycle?
The volatility markets experienced the most publicity in 2020 compared to recent years due to the large movements in markets in March. Both the US and Hong Kong volatility indices began the year extremely low before exploding to multi-year highs in March. This year, the CBOE Volatility Index (VIX) increased from the year trough of 12 in mid-January, to a peak of 83 in mid-march, to settle to a more medium level of 23 at the end of year. In Hong Kong, the Hang Seng Volatility Index (VHSI) was similar, increasing from the year trough of 14 in mid-January, to a peak of 64 in mid-March, before settling down at 20 to the end of the year (Figure 1). To add a little more depth into the numbers and to understand the environment of the volatility markets for 2020, it would be helpful to quantify these movements while comparing the similarities and differences between the US and Hong Kong volatility markets.
Figure 1: 2020 VIX & VHSI
Source: Refinitiv, Pinerion Research
To put in context how dramatic the volatility movements in 2020 was, the VIX and VHSI both made movements greater than 5 standard derivations (“5-sigma”). Theoretically, 5-sigma movement should happen roughly only once every 6,921 YEARS on a normal distribution. This year alone, we had FIVE 5-sigma movements for the VHSI, and FOUR 5-sigma movements for the VIX (Figures 2 & 3). Incredible! In the past twenty years, both the VHSI and VIX have had 16 and 14 days of 5-sigma movements historically respectively, meaning 2020 accounted for 31% and 29% respectively of these movements over the last twenty years! In fact, 2020 had the most 5-sigma moves for both the VHSI and VIX since 2001, with the last 5-sigma move occurring in 2018. It is also interesting to note that ALL 5-sigma events have happened since the global financial crisis in 2008 and the onset of quantitative easing (Figure 4), reflecting the increasing fragility of the markets.
Figure 2: VHSI Daily Moves since 2000
Source: Refinitiv, Pinerion Research
Figure 3: VIX Daily Moves since 2000
Source: Refinitiv, Pinerion Research
Figure 4: Number of Five-Sigma Moves
Source: Refinitiv, Pinerion Research
While the US and Hong Kong volatility markets usually move in tandem, another unusual takeaway from the volatility markets this year, is that the historically more volatile Hang Seng Index, has been way less volatile than the US market. As a simple comparison, during the GFC in 2008, the VHSI peaked at 104, while the VIX peaked at 80. During the March pandemic, the VHSI “only” peaked at 65, while the VIX peaked at 83. The spread between the VHSI and VIX has averaged 2.9 over the last 19 years, but in 2020, this spread has averaged -3.9, a huge diversion from the mean (Figure 5). The same conclusion can be observed from the realized volatility as well. The graph below compares the rolling 20 day realized vol between the S&P500 (SPX) and the Hang Seng Index (HSI) (Figure 6). Not only was the HSI realized vol for March less than half of that in the 2008 GFC, the SPX realized vol surpassed that of 2008 as well. On a relative basis, during the March crash, the SPX was more volatile than the HSI in over fifty years of historical data with a spread of over -56!
Figure 5: VHSI vs VIX Spread
Source: Refinitiv, Pinerion Research
Figure 6: HSI vs SPX Realized Volatility (Rolling 20D)
Source: Refinitiv, Pinerion Research
Why has market volatility been increasing?
While the reasons of increasingly volatile markets were discussed in our pervious memo, it is still worth mentioning a few theories that stem from both fundamental and technical factors. Regarding fundamentals, corporates have taken on a record amount of debt, both in absolute terms and relative to earnings. The rise in leverage was in part due to increasingly low interest rates, incentivizing companies to increase the proportion of debt into the capital structure as the cost of debt falls. However, leverage does not increase returns, but rather amplifies returns, regardless if those returns are positive or negative. In short, the value of equity will be more sensitive to the market cycle, which in turn will increase market volatility.
On the technical side, structural changes over the last few decades have further increased market volatility. For example, the rapid growth in the derivatives market along with the rise in algorithmic trading, volatility-targeting funds, risk-parity funds, leveraged ETFs, may be structured in a way that intensify market movements in a downturn, such as being forced sellers as the market is falling or volatility spiking. This trend looks to continue, as record-low interest rates are forcing investors to take on leverage to hit target returns, either explicitly by taking on leverage such as buying on margin, or implicitly by moving up the risk-curve by buying increasingly riskier assets or products to seek better returns. In Asia, this is ever prevalent with the exponential growth in structured products. Mixed with massive inflows over the last two decades to passively managed strategies that create indiscriminate buyers and sellers that distort price discovery, it would not be surprising that these structural fundamental and technical trends will further exacerbate market volatility going forward.
How has the HK Derivatives market changed in 2020?
Not only have the Hong Kong volatility markets been thrilling from both a returns and diversifier standpoint, the growth of the liquidity and the choice of derivative products in 2020 listed on the Hong Kong Exchange are exciting as well. In terms of product offering alone, there was a 69% increase (Figure 7) in number of derivative products listed on the HKEX in 2020, which was largely driven by MSCI migrating the licensing for derivative products to Hong Kong from Singapore, a move which cemented Hong Kong’s role as Asia’s’ premier derivatives hub. In addition, the newly launch Hang Seng Tech Index this year will serve as the city’s flagship benchmark of the region’s growing technology champions. The index represents the 30 largest technology companies, including heavyweight Chinese tech giants such as Tencent, Alibaba, and Meituan. This is more relevant now than ever, as many US-listed ADRs will follow in the footsteps of Alibaba, NetEase and JD for a “homecoming” listing in Hong Kong. Many of these homecoming companies have tradable options the day of listing, and some are already the most liquid and popular contracts on the market. This trend should continue, as more and more companies opt to have a listing in Hong Kong. Potential homecoming ADRs include Pinduoduo, Vipshop, and Bilibili just to name a few. In other words, the Hong Kong derivatives market is becoming a proxy to play the China volatility market.
Figure 7: HKEX Derivative Contracts
Source: HKEX, Pinerion Research
In terms of liquidity, for derivatives, Hong Kong has slowly pulled ahead of its regional competition as the regional derivatives hub. When we look at the derivatives market liquidity, as indicated by the open interest, Hong Kong has continued to show strong growth compared to Korea and Japan. Open interest on futures and options on all contracts listed on the HKEX reached an all-time high in 2020, and is up over 73% YoY (Figure 8).
Figure 8: Hong Kong Derivatives Market Liquidity
Source: HKEX, Pinerion Research
When we look at the 5-year and 10-year trends of open interest growth, Hong Kong by far has the strongest momentum. Index open interest has increased 25.7% CAGR over the last ten years, compared to -7.5% CAGR for Korea and 0.5% CAGR for Japan (Figure 9). Thus, as the Chinese economy continues to grow and the capital markets continue to open up, Hong Kong will continue to be the ideal destination as the financial capital of Asia serving as a conduit between the East and West.
Figure 9: Asian Derivatives Index Open Interest
Source: HKEX, KRX, JPX, Pinerion Research
Note: Hong Kong Index Options (HSI, Mini HSI, Weekly HSI, HSCEI, Mini HSCEI, Weekly HSCEI), Japan Index Options (Nikkei 225, Nikkei 225 Weekly, TOPIX), Korean Index Options (KOSPI 200, Mini KOSPI 200, KOSDAQ 150)
The Opportunities Ahead
As the dynamic Hong Kong and Chinese derivatives markets continue to grow both in size and importance to the global markets, many opportunities arise in the volatility space to complement an investor’s asset allocation. As the benefits of the traditional 60/40 portfolio becomes increasingly uncertain, volatility strategies can be a potential alternative to bonds as interest rates approach a historical low. Volatility also displays low correlations to other asset classes, which can be used to enhance portfolio diversification and improve risk-return profiles. With the strong product offering and liquidity of the Hong Kong’s derivative markets, there are many strategies that can capitalize on this normalizing volatility environment on both the long and short volatility side. Volatility strategies such as dispersion or relative value trades can capture potential inefficiencies in the market, short vol strategies can extract the volatility risk premium to provide income, and long vol strategies can provide portfolio protection in a market downturn. A combination of a volatility specialist with local market knowledge to understand the idiosyncrasies of the Asian markets will be key to unlock the value available in the Hong Kong derivatives markets, and we are absolutely optimistic for the prospects of this asset class to perform well under all weather conditions.
Closing remarks
As the global economy recovers in 2021 and gradually reopens, there are still many risks that need to be monitored carefully. From increasing geopolitical tensions to swelling global debt balances, the fragility of the markets will continue to climb. At Pinerion, we strive to generate uncorrelated returns to our investors. Finally, we wish you and your family continued good health and safety!
Disclaimer: Please note that the contents of this publication should not be construed as investment advice. Further, it should be noted that this publication should not be construed as the solicitation of an offer to purchase or an offer to sell an interest in any private investment fund managed by Pinerion Asset Management Limited and its affiliates (“Pinerion”). Finally, please note that (to the extent that performance information is contained in this publication) – past performance is not necessarily indicative of future returns. All rights are reserved.