March 6, 2015 / 2:15 PM / 4 years ago

Hedging demand signals confidence in U.S. stocks shaky

* Demand for VIX hedging surges as market climbs

* Flows into VIX ETFs jump in Feb - Markit

* Heavy flows into equities seen raising risk of reversals

By Francesco Canepa

LONDON, March 6 (Reuters) - Investors put more money in February into hedging against a U.S. stock market fall than in any month for almost two years, signalling confidence in the market’s surge to all-time highs may be shakier than it seems.

The prospect of a rise in U.S. interest rates and concerns a sell-off could be on the cards have stoked demand for exchange traded funds (ETFs) tracking the VIX volatility index. The VIX measures the cost of U.S. stock options and tends to rise when the S&P 500 index falls, and vice versa.

While VIX-tracking ETFs can also be deployed as part of complex arbitrage trades, they are generally used by funds across the world to reduce, or “hedge”, their equity exposure.

A basket by data provider Markit of 61 ETFs which track the VIX raked in nearly $600 million dollars in February, the biggest monthly inflow since July 2013. This left the funds’ assets up 10 percent on the month at $2 billion, despite a 36 percent slump in the value of the VIX.

“People are buying equities yet they’re using long VIX exposure to hedge the downside,” Joanne Hill, head of investment strategy at ETF provider ProShares, said.

The bigger picture is not yet one of worry: the VIX is currently languishing close to a two-month low at around 14 while the S&P 500 and Germany’s Dax indexes are hovering near all-time highs. Billions of dollars flow into stock funds every week and investors have become more bullish about the global economy.

Yet memories of two sharp equity sell-offs last year, which sent the VIX as high as 31 points, are leading many to believe more volatile times will return, compared with the becalmed market environment seen over the previous two years.

Investors single out a rate increase in the United States, expected for the summer, as the most likely driver of any future volatility spike, given the large number of corporate and sovereign borrowers that depend on dollar financing and the ructions it could cause in commodity prices.

The fact that so many investors have bought into the equities rally could also exacerbate a sell-off.

“We’re long volatility,” said Gilbert Keskin, co-head of volatility, arbitrage and convertible bonds at Amundi.

“Everybody is doing the same thing at the same time, meaning that you could see in the near future some strong movement from an asset class to another which could generate ... a spike in volatility.”

Hedging comes at a cost, however.

Investing in the VIX via rolling future contracts or exchange traded funds based on futures, such as the VXX, can be very expensive if volatility stays low.

This is because VIX futures with an expiry date further into the future are currently more expensive than shorter-dated ones.

“It’s incredibly painful to hold the VXX for more than the very short term,” Lorne Baring, managing director at wealth manager B Capital, said.

Net VIX positions: link.reuters.com/cud34w

Shares in VIX ETFs vs VIX: link.reuters.com/nev24w (Editing by Mark Potter)

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