By Neil O’Hara
Going long the stock market in 2008 was almost a guaranteed way to lose money. But those who made long bets on market volatility enjoyed a different outcome.
Volatility arbitrage players don’t invest in the market but rather in how much the market bounces around. Managers who were long volatility did extremely well in 2007 and 2008, when markets crashed. But these same managers struggled in 2009 as the panic subsided and markets calmed down. That’s no surprise, given that volatility tends to fall whenever the market drifts up but tends to rise whenever the market declines. Given the level of economic uncertainty in today’s markets, however, the handful of managers who trade volatility as a stand-alone strategy may be poised to post bigger gains in 2010.
“We are excited about the opportunities ahead, with macro issues like sovereign debt and currencies melting down,” says Ross Berman, managing member and portfolio manager at BAM Capital, which manages $307 million in volatility arbitrage programs.
Whether these managers will post gains from volatility in 2010 depends on how they trade it, however. The biggest players in volatility arbitrage are securities firms and large multistrategy hedge funds—such as CQS in London, Millennium Management in New York and Citadel Investment Group in Chicago—that tend to be short sellers of volatility. But a handful of single-strategy hedge funds focus purely on volatility, and these players tend to be mostly net long or net neutral rather than net short.
There are many ways to play volatility, and the narrow universe of volatility arbitrageurs is highly diversified, with few managers executing the same strategies.
This is reflected in the returns of some of the best-known volatility arbitrageurs. Some players took a beating last year when the rest of the world recovered. Several others posted gains, though not quite at the same lofty levels as 2008. The biggest of these stand-alone funds, Amundi Asset Management’s $1.9 billion Amundi Funds Volatility Euro Equities, a directional volatility strategy, gained 6.53% in 2009 after netting an impressive 23.48% in 2008. (The fund was previously known as the CAAM Funds Volatility Euro Equities Fund; Amundi Asset Management was formed when the asset management arm of Crédit Agricole merged with the asset management arm of Société Générale in 2009.)
The firm’s $367 million Amundi Funds Volatility World Equities—also directional—rose 8.53% in 2009 after a gain of nearly 26% in 2008. By contrast, F&C Investments’ F&C Sapphire Fund, a volatility-neutral strategy, gained 14.15% in 2009 after rising 2.18% in 2008.
The best-known measure of volatility is the CBOE Volatility Index—known as the VIX—which measures the volatility of the S&P 500 Index. But volatility investors are not limited to equities. In practice, they can invest in options or instruments that have an option component, because volatility is a key factor in options pricing models. The instruments that volatility arbitrage managers trade include listed equity, index, commodity or currency options traded on stock exchanges, futures or options on volatility indices, customized OTC derivatives, or convertible bonds.
Maple Leaf Capital, a London hedge fund manager, places volatility bets on fixed-income instruments, foreign currencies, commodities and equities in the $191 million Maple Leaf Macro Volatility Fund. It aims for a net-neutral stance but goes long volatility it perceives as cheap and sells short overvalued volatility in other instruments or asset classes. The fund beat most benchmarks for the underlying asset classes in 2008—although it still lost 9.29%—and it struggled in 2009, finishing the year with a loss of 4.34%. But the fund was up 6.10% in January alone.
Michael Wexler, chief executive and chief investment officer at Maple Leaf, expects markets to remain choppy this year because the rebound in financial asset values may have outrun the recovery in the real economy. “This is probably a time for nimble trading more than anything else,” he says. “Volatility curves are pretty flat. Buying short-dated relative to longer-dated volatility creates a book that forces you to trade the underlying spot or short-dated assets to maintain your hedge.”
Being long volatility gives investors an insurance policy that pays off when disaster strikes, but like any other form of insurance, it isn’t free. “No insurance company will let you have a policy and not pay for it,” says James Skeggs, manager of quantitative analysis and statistical reporting in the London office of Newedge Group, an institutional broker that also compiles the Newedge Volatility Trading Index. In every case, the option buyer has to pay a premium over the intrinsic value of the underlying instrument—a premium that erodes over time until it vanishes completely, which happens when the option expires.
That erosion of value day by day is known as time decay—or theta to options aficionados—and it is the bane of long-volatility arbitrage strategies. Managers have to find a way to recover the cost or they will steadily lose money. Worse, under normal conditions, options prices imply that volatility between the date an option is purchased and the expiration date will be higher than it usually turns out to be—in other words, implied volatility exceeds realized volatility.
That means buyers pay too much for volatility most of the time—except when the market goes haywire. Between this and the time decay phenomenon, long-volatility players start out with two strikes against them, and each manager uses a different technique to overcome that handicap.
Berman combines fundamental analysis with a quantitative approach. BAM’s flagship BAM Opportunity Fund runs a long-volatility book, a strategy designed to cash in when panic grips the market. The fund focuses on single-stock and equity-index options, looking for opportunities to buy volatility that looks cheap relative to the historical average—and for no good reason. “We try to understand the fundamental outcomes and not just play mean reversion,” explains Berman. “By combining the two, we have a way to express bets in volatility, a market that is not followed as closely as individual stocks.”
Not surprisingly, managers who sold volatility short had a good year in 2009—provided they survived. Short volatility isn’t a portfolio hedge; in fact, many managers who had delivered steady positive returns for several years gave it all back and then some in a matter of days or weeks after Lehman Brothers failed.
1In effect, these players write the catastrophe insurance policies long-volatility managers buy. They sell option premiums, which means they win big as long as implied volatility exceeds realized volatility but get killed when disaster strikes. Few, if any, independent hedge funds run naked short-volatility books, a strategy Skeggs says is akin to “picking up pennies on the train tracks.” The strategy flourished before the crisis at multistrategy funds and bank proprietary trading desks.
Independent short-volatility players typically have tight risk controls to keep a lid on losses when volatility ticks up. Ron Dodson, a portfolio manager at the Dallas firm NorCap Investment Management, a $100 million volatility arbitrage manager, extracts the premium of implied over realized volatility by selling short-dated equity index options, rolling the position over to the next expiration date every month to enhance the returns on his core portfolio of short-duration government and agency bonds. “We think of ourselves as insurance underwriters,” says Dodson. “We get paid to mitigate the risk that realized volatility turns out to be greater than what implied volatility predicted.”
The options market itself helped Dodson dodge a bullet in 2008. In early September, before the big drop in equity prices, realized volatility swung to a premium over implied volatility. “That tipped us off,” he says. “I was almost completely out of the market for six and a half weeks. It made no sense to sell premium at wholesale prices and have to buy it back at retail.”
NorCap uses hard stop-loss limits to offset the risk of being short. In its Diversified Premium Fund, for example, if losses exceed 2.5% in a single month, it starts to cut back the options positions and is out of the options market entirely by the time losses hit 5%. “It keeps us out of the big trouble,” says Dodson. “We are very disciplined about that.” The NorCap Diversified Premium Fund was up 7.78% in 2008—a year when the S&P 500 declined 38.5%—and returned 11.72% in 2009.
Volatility arbitrage managers became victims of their own success in late 2008. Their portfolios typically have short durations and few restrictions on liquidity, which left them vulnerable to redemption requests when other hedge fund managers put up gates. “We were treated like the bank,” observes Dodson. “We were at $225 million at that point, performing well when nothing else was. But sometimes you do well and the money goes away.”
Managers of volatility arbitrage strategies don’t require a long or short bias. F&C, a London-based money manager whose $156 million Sapphire Fund derives part of its returns from volatility, steers a middle course. “There are not many hedge funds that have a short bias left, and anyone who was long volatility had a tough time last year,” says Stephen Crewe, portfolio manager. “We are more balanced, so we tend to survive the ups and downs in the market.”
Instead of offering investors crash protection, Crewe tries to extract alpha from the options market. The Sapphire Fund isn’t a pure volatility play; it trades other elements in options pricing, though Crewe admits these instruments all have an element of volatility to them. “Pure volatility arbitrage is such a small space,” he says. “There are a limited number of equity indices in the world, and they tend to be highly correlated. A long position in DAX volatility is not that different from a long position in Euro Stoxx volatility.” Liquidity in single stock options dried up after Lehman failed, which crimped Crewe’s ability to pursue that avenue, too.
In its early years, the Sapphire Fund had a short-volatility bias, but a sharp setback in May 2006—it lost 4.35% that month—prompted Crewe to rethink his strategy. As a general rule, he has become more cautious—putting a cap on any short-volatility bets, for example. That policy prevented potentially catastrophic losses when a short bet on Volkswagen volatility went sour in fall 2008. The new approach has served investors well, given Sapphire’s gains in 2008 and 2009.
The prospect of higher volatility in 2010 is bad news for ordinary investors but good news for Berman and BAM, which recently hired a macro analyst to extend its reach beyond equities. “We think the long-volatility trade makes sense, and we hope to take advantage of what could be a significant move to the downside in the underlying markets,” says Berman. “We want to make more money than everyone else when everyone else is losing.”
