This may be another example, in other words, of a growing “index effect” on equity market behaviour (chronicled by Jeffrey Wurgler in a recent issue of the Journal of Indexes Europe). Wurgler notes increasing valuation distortions in large-cap equity benchmarks like the S&P 500 and suggests that the increasing use of indexed portfolios is the prime cause for such anomalies.

But another type of exchange-traded product may also have played a role in pushing up index correlations.

VIX-based volatility ETPs have attracted a lot of interest in recent years. Purchasers of VIX trackers are effectively buying index put options.

Since the CBOE’s implied correlation index is calculated as the difference between the implied volatility of index options and the implied volatilities of options on the index’s component stocks, it’s possible that a rising correlation index could simply indicate that market participants have been overpaying for index options. And VIX-based ETPs may be behind this steady, valuation-indifferent “bid”.

One hedge fund, Och-Ziff, was reported last year as having taken the opposite side of the trade to VIX ETPs, placing a US$12 billion bet on US stock correlations having peaked. Och-Ziff wouldn’t be the only player in the market to have taken the view that purchasers of VIX trackers are effectively burning their money.

We’ve also written in the past that investors should avoid volatility trackers, at least the naive ones that incur huge roll costs. The increasing divergence between the value of index options and options on the index’s components is even greater reason to shun trackers like VXX, VXZ and their European equivalents.

But even if most VIX-based ETPs aren’t worth investing in, VIX has always been widely interpreted as a useful aid to market timing. Now, however, it seems that the volatility index by itself may be an insufficient gauge of the share market’s health, and we should all be paying much more attention to internal index correlations.

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