Volatility has remained low for more than a year now, and short interest in the VIX has followed suit, reaching new highs in August 2013 when investors expected then Fed Chairman Ben Bernanke to pull the trigger on tapering. But hedge funds, which normally sell the VIX anyways, have been shedding their short positions and will soon become net buyers of volatility.

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Hedge funds have a short VIX bias

“Historically, and in combination with long equity positions elsewhere, hedge funds have a strong natural bias toward net selling the VIX,” writes Societe General analyst Alain Bokobza. “After all, with the forward market for VIX still in strong contango as it is currently, without a rise of the VIX it costs money to be long and it pays to be short.”

An asset is in contango when its futures price is higher than the expected strike price in the same timeframe (the opposite of downardation). Contango normally makes sense when an asset has a storage cost (eg oil) and a trader would rather pay more now in lieu of dealing with storage. Since VIX is currently in contango, and holding a position on the VIX doesn’t have a storage cost attached to it, you would expect there to be a bias towards shorting, which makes the absence of net sellers really surprising.

Volatility has dropped a bit recently, which would offer a nice entry point for hedge funds to start buying the VIX, but that doesn’t explain the three-month trend or the net long position. Bokobza says that the possibility of escalation between Russia and the West could drive volatility, but he doesn’t think that actually explains such a strong trend either.

Hedge fund positioning goes against the consensus view

The other explanation is that hedge funds have a different opinion about the expected VIX strike price and that they are buying because they think futures are currently underpriced. Anything else would be reason to reduce the net short position, but this looks like a strong consensus on where the economy is headed, not just a short-term maneuver that a few fund managers have picked up on.

For investors who might want to follow suit, there doesn’t seem to be much downside. The VIX is currently at 13, compared to a 52-week range of 11.69 – 21.91. Even for a year of low volatility, the current level doesn’t have that much further to fall.

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Sources for all tables on this page: CFTC, SG Cross Asset Research/Global Asset Allocation