The sultans of swing

May 3, 2013

Although most investors have been pleased with the steadily rising U.S stock market over the past six months, funds that profit when markets are convulsing are licking their wounds.

With market stress at multi-year lows, volatility hedge funds returned just 1.16 percent in the first quarter, compared with 3.7 percent for the broader hedge fund group.

Some of the volatility specialists are doing better than others by capitalizing on major market moves in Japan, for example. And some are doing better simply because they are ‘short’ volatility funds – they tend to perform better when markets are calmer. But those funds are now few and far between.

“If I were to turn the clock back there were a lot more short volatility funds than long in 2004,” said Joshua Thimons, a portfolio manager at PIMCO. “There are fewer now – 2008 wiped most of the face of the map.” Short volatility funds earn a risk premium by selling volatility in the markets, capitalizing on the fact “that some managers use it as tail hedging,” he explained. “These funds have done better this year, but there are fewer of them.”

The problem the long volatility funds face right now– and long vol funds now make up the lion’s share of the strategy – is that, quite simply, there’s not a lot of volatility. Even the short volatility funds require some degree of movement in the market for there to be a relative value opportunity to exploit.

And with central bankers around the world doing their best to make sure markets are stable with monetary and fiscal stimulus aplenty, this low-vol situation may not be fleeting. The Wall Street barometer of investor anxiety, the VIX index, hit a six-year low in March.

Stress-free markets have also impacted a lot of tail risk funds, which attracted a bucket-load of capital after the financial crisis. Investors are backing away after months of poor performance, as Reuters reported earlier in April.

Todd Petzel, the chief investment officer for Offit Capital, which advises on $7 billion for wealthy investors, emailed us on this very issue:

Some hedge funds used to say they could always find cheap options to provide the chance for highly asymmetrical returns patterns.  That hasn’t been true for a while and these funds have been hurt over the last few years by buying relatively expensive insurance against events that haven’t happened. With vols being lower than average now, the cheap insurance thesis may once again be coming into play.  Of course, there are reasons why some insurance policies are dirt cheap – there really isn’t any risk.

Strangely enough, despite calmer markets, the volume of volatility derivatives is at record highs, according to Menachem Brenner, a professor of finance at NYU’s Stern School of Business. Brenner also said that “volatility of volatility is relatively high” at the moment, which creates greater price dislocations in the market, which is a good thing for vol traders.

It also explains why volatility arbitragers aren’t too cynical about the opportunity for returns in coming months. One of those managers is Mike Belbeck, who used to trade derivatives at Credit Suisse and Deutsche Bank (and got his start on Wall Street working for hedge fund billionaire Ken Griffin) and launched a volatility arbitrage fund, Holworthy Capital, in April.

As the vol funds suffer, hedgies who were killed by wild market swings over the past few years are enjoying the spoils of stress-free markets. “The traders have been having their way for quite a while,” said one long/short hedge fund manager. “Finally, the investors are getting theirs. ”

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