Hedge Fund 36 South Gains as Central-Bank Shocks Hurt Peers

Article in Bloomberg

by Netty Idayu Ismail

12:14 AM WET February 17, 2015

(Bloomberg) -- 36 South Capital Advisors is profiting from central-bank surprises that roiled markets over the past six months and spurred losses among hedge-funds rivals that also seek to gain from volatility.

The manager’s [flagship strategy], which bets on rising price swings, [gained] in January, adding to its [considerable] return in the fourth quarter, Chief Investment Officer Jerry Haworth said. That reversed losses suffered as volatility evaporated from 2012 through the first half of last year. The HFRX global volatility index of similar hedge funds lost 1.7 percent in the three months ended Dec. 31.

“With central banks taking a larger controlling role in the markets, especially in the interest-rate space, prediction is made more difficult,” Haworth said in an e-mail interview. “Whilst we probably cannot predict what event will cause volatility, the odds are in our favor.”

JPMorgan Chase & Co.’s Global FX Volatility Index surged to a 19-month high on Jan. 16, the day after the Swiss National Bank scrapped its three-year policy of capping the franc against the euro. Price swings of U.S. debt, as measured by Bank of America Merrill Lynch’s MOVE Index, soared last week to the highest since October, while expectations for oil to fluctuate climbed on Feb. 5 to the highest level in almost six years.

Haworth said he moved to London from Auckland in 2009, when he was managing about $40 million, as investors were overlooking the firm because of its location - even after its [left tail strategy] returned [signficant gains] during the global financial crisis in 2008. He said 36 South, named after the latitude where New Zealand’s largest city is situated, now manages $900 million.

‘Crisis Hedge’

“The objective of most volatility hedge funds is that they should make small amounts of money consistently, but be an excellent ‘crisis hedge’,” said Peter Douglas, principal of Singapore-based research firm GFIA Pte. “The natural tendency of a volatility strategy is to lose money in normal circumstances, so to make money the manager has to be a skilled arbitrager.”

Policy makers from Australia to Canada bucked forecasts by cutting interest rates this year, while the European Central Bank announced a bigger-than-expected asset-purchase program, sending bond yields to record lows. The SNB abandoned its 1.20 per euro ceiling just days after officials had signaled no plan to change.

‘Market Intervention’

Stephen Diggle, who co-founded a hedge fund that made $2.7 billion for investors as markets see-sawed in 2007 and 2008, said he isn’t convinced the spike in volatility will last. Diggle, chief executive officer of Singapore-based family office Vulpes Investment Management, liquidated his previous firm’s volatility funds in 2011 after price swings declined.

“It’s noteworthy that the only recent major piece of volatility, in the Swiss franc, was due to central-bank action, not organic markets,” Diggle said. “In a post-2008 world, governments and central banks are constantly vigilant of capital markets volatility and their potential intervention to reduce it represents a permanent change in the volatility landscape.”

The Chicago Board Options Exchange Volatility Index, or VIX, averaged about 14.2 a day last year, the lowest reading since 2006. The VIX, known as Wall Street’s fear gauge, reached a record high 80.86 in November 2008 after Lehman Brothers Holdings Inc.’s collapse.

Volatility Returns

“Volatility is low, courtesy of quantitative operations across the world that tend to keep markets under control; when cash is abundant and interest rates are low, equities tend to go up and volatility is reduced,” said Stephane Pizzo, managing partner of Singapore-based Lotus Peak Capital, which invests in hedge funds. “But what we have seen recently is that volatility is back in currencies, possibly because the foreign-exchange market is global in nature and is very difficult to control.”

36 South buys long-dated options it considers cheap, betting unforeseen events will generate large profits across currency, interest rates, equities and commodity markets. It prefers options with more than a year to maturity, Haworth said.

Interest-rate volatility is set to rise as the Fed withdraws its asset purchase program, known as quantitative easing, Haworth said. 36 South holds positions that could benefit from this, including payer swaptions, or options on interest-rate swaps, which increase in value as rates rise, he said.

‘Wild Card’

Futures traders are placing better than 80 percent odds on the Federal Reserve raising benchmark borrowing costs by year-end for the first time since 2006.

“We expect the quantum of rates rise to be unexpected, rather than the upward direction, which is widely anticipated starting in the U.S.,” Haworth said.

The manager profited last month from options to sell the euro, which tumbled to an 11-year low of $1.1098 on concern Greece would exit the currency under the new government, Haworth said. The fund also made money from options to sell U.S. stocks and contracts to buy European stocks, he said.

“The euro value is a wild card and the rate could fluctuate wildly in the face of increased uncertainty in the coming months,” Haworth said. “Parity could well be on the cards.”

Volatility Drivers

Philip Moffitt, head of Asia-Pacific fixed-income at Goldman Sachs Asset Management in Sydney, said he expects market volatility to persist.

“We’ve got divergence between the U.S. and the rest of the world,” Moffitt said. “That increase in uncertainty because of divergence means we should have more risk premium.”

36 South’s own index shows that the value of global volatility, implied by prices for options, is still below the average since 2006, said Haworth, who founded the firm in 2001 along with Richard Hollington. The index excludes the effects of interest rates as the near-zero borrowing costs prevalent in many major economies would skew the gauge’s readings, he said.

“Very few people predicted the Swiss central bank action,” Haworth said. “We think we know what the drivers of volatility will be, but we almost never do.”

To contact the reporter on this story: Netty Ismail in Singapore at nismail3@bloomberg.net

To contact the editors responsible for this story: Garfield Reynolds at greynolds1@bloomberg.net Tomoko Yamazaki