We all recall Mary Shelley’s novel Frankenstein, written in the early 19th century. It tells the story of Dr. Victor Frankenstein who creates a grotesque monster in an experiment and then brings it to life. The creature seems civilized at first, even reading books, but then falls into fits of rage and goes on a murderous rampage, partly as revenge on his creator.
Now a similar story is unfolding in capital markets. This article profiles Devesh Shah, an applied mathematician and hedge fund manager who formerly worked for Goldman Sachs. Shah was one of the creators of the CBOE Volatility Index, which is traded in derivative form as VIX.
For many years, VIX served as a useful guide to market views on volatility and as an early warning of choppy markets. But lately VIX has turned into a monster. VIX is the basis for a host of derivative products, ETFs and ETNs, some of which use extreme leverage and offer returns promised to be the inverse of the VIX itself.
This structure means that if VIX rises 100%, the inverse VIX product falls 100% and is totally wiped out. These products are now traded all over Wall Street and are embedded in many portfolios. This diverse, leveraged and opaque group of contracts now produces unforeseen destruction when volatility spikes as it did last week.
Like Dr. Frankenstein, Devesh Shah now has regrets about his creation. Shah says, “In my wildest imagination I don’t know why these products exist.” Shah deserves credit for candor, but unfortunately, the monster is still on the loose.
Many more portfolios will be destroyed and hidden losses will emerge before the VIX monster is finally constrained.