Equity correction and tail-hedging with market makers

The MSCI World was down 1% yesterday extending the drawdown to 5.5% which naturally attracts the ‘buy-the-dip’ flow betting on a quick reversal as we have seen so many times. But is this time different? The current energy crunch and rising commodity prices is the worst since the energy crises of 1973 and 1979, and will have profound impact on companies, households, and inflation. In our view risks are skewed to the downside in equities and the correction has not even remotely exhausted itself. The VIX futures spread between the two nearest contracts measures the curvature of the first part of the volatility curve on equities and the spread is currently only 3%. In other words, the VIX futures curve is still in contango. During more profound corrections, the curve flips into backwardation with -20% being the level for a mild correction and more than -40% for severe corrections. Given the current VIX futures curve there is plenty of downside risks should power prices continue to increase.

Puts, futures, or market makers?

In our August research note Tail-hedging with market makers we argued that publicly-listed market makers such as Virtu Financial and Flow Traders have remarkable hedging capabilities because market makers are naturally long volatility. But even more importantly because of a positive drift in volume over time in financial markets these market makers are also experiencing a positive drift in their share price. This means that investors can get tail-hedging without the negative expected returns that are typical of option or VIX strategies. As the correlation matrix below shows these two market makers have zero correlation to the MSCI World and the correlation between them is low. This means that Virtu Financial and Flow Traders possess great diversification contribution to a portfolio and that both should be owned as they are correlated and are capturing different things from the flow.

The two market makers went public in 2015 so we only have limited data points but still a couple of equity market corrections to lean on. Using quantile regression techniques we can model the distribution of returns for Virtu and Flow Traders given the percentiles of returns in MSCI World. Since April 2015 the 1%-percentile is -2.8% daily return with the worst daily return being -10.4%; in other words, very fat tails in global equities since 2015. As the histogram below shows, Virtu and Flow Traders have 37% and 56% probabilities for having a positive return during a -2.8% daily return in the MSCI World. The mean expected return for Virtu and Flow Traders is -0.44% and 0.17% respectively indicating the capital preservation capabilities during equity market stress. Both Virtu and Flow Traders have had a positive cumulative return during the current equity market drawdown, and this is even without backwardation in the VIX futures curve and real stress.