Lately, the VIX has been acting rather strange. While on the surface, the volatility index has behaved much as expected, sliding to near all time lows while the S&P reached daily record highs, beneath the surface some unexplained movements have been observed.

On one hand, as we reported yesterday, speculative VIX shorts have hit an all time high, while options in both the DJIA and Nasdaq signal ongoing record highs ahead.

This is not unexpected, and neither is that, as DB points out, both realized and implied vol in US equities is near 2 year lows.

Things get more complex when we step away from VIX futures and options, and enter into VIX ETF territory. Here, there is a notable divergence, because as DB adds, the drop in vol has been accompanied by large inflows into long vol fund products and outflows from short vol funds suggesting investors positioning themselves up for a rise in vol down the road.

To be sure, we have observed the curious discrepancy between VIX futures and ETFs last September, as well as the reflexive loop that seems to emerge on the underlying market when simply trading VIX futs or ETNs, most recently in an extended discussion last September on how potential "VIX manipulation runs the entire market", when the FT picked up on a topic we have long discussed, pointing out the upsurge in stock market turmoil during August as "exacerbated by specialised exchange traded funds that track volatility" adding that "there is a layer of separation between the Vix and Vix futures, and the ability to uncover any effect is challenging,” said Scott Weiner, head of ETP quantitative strategy at Janus Capital, which owns VelocityShares. “It’s a small impact, if at all."

This all goes back to the reflexivity of the market with its "derivative products", in this case the S&P500 and the VIX, only where things get substantially more complicated is that there is no longer one derivative, i.e., futures, but two, when one includes the impact of vol ETFs.

It also means that if one were so inclined, one could impact the broader market, at first by focusing on the VIX future contracts, and then on VIX ETFs.This is also where traditionally things would get very confusing, as putting a comprehensive picture of the various relationships has been a particularly difficult exercise.

Conveniently, a recent analysis from Russell Clark of the "world's most bearish hedge fund", Horseman Capital Management, does a terrific job of explaining how the relationship between the market and its two key underlying volatility traded products has changed over time, and where we find ourselves at this moment.

More importantly, in 'VIX and VIX ETFs: Volatility is no longer an independent variable", Clark explains why VIX is now a fundamentally broken product. For all those who trade VIX, and rely on the indicator to gauge overall market complacency, this is a must read report.

From Horseman's Russell Clark (pdf)

In other words, the VIX, and by implication the entire topology of market volatility - because the reflexivity we first hinted at years ago, is now being confirmed by Horseman which says that products "influence the market they are meant to mimic" -now appears to be broken, due to the numerous direct and indirect ways that both traders and algos are impacting the underlying market through products that were meant to be mere "mimicking" derivatives, often in contradictory ways.