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Readers of on my JubakAM.Com site in comments to a number of my posts recently have been kicking around the question of whether the huge increase in passive investing strategies has changed volatility in the stock market.

Passive investment strategies such as indexing now make up half of all trading. That’s twice the percentage of 10 years ago

Alberto Gallo, a portfolio manager who runs the Algebris Global Credit Opportunities Fund, took a deep dive into the question on Bloomberg yesterday.

His conclusion (

Volatility in general has collapsed in the era of quantitative easing. But when volatility does increase, it has generally risen unusually quickly.

Gallo took a look at the CBOE S&P 500 Volatility Index (VIX). It is more likely to stay below 20 right now, he concluded, than it was in the pre-quantitative easing period. But it is more than twice as likely to surge to more than 40 when it does climb

The result is a pattern of fatter tails in comparison to the period before quantitative easing. The odds of a surge in the VIX to above 35 are small but they are about twice as high as they were in the period before quantitative easing flooded the market with cash and passive strategies put the cash to work in market cap weighted vehicles that wound up chasing market winners. (You can most clearly see this pattern in the graph as the Gallo and Bloomberg put together. I urge you to take a look at the free site.)

Gallo also suggests that besides quantitative easing and passive investing strategies, the other factor leading to fatter volatility tails is a decline in the power of market makers who, once upon a time, carried enough inventory to damp volatility. Market makers, Gallo notes,  hold a tenth of the trading inventories they had in 2007, according to data from the Federal Reserve Bank of New York.

In his post Gallo argues that the era of quantitative easing has ended the period when a 60/40 stock to bond portfolio allocation made sense. The question of what to replace it with has been the subject of quite a few posts on this site and of my Special Report on Investing for Retirement. (Which you can find in the Special Reports section of the JAM.Con site.)