Vol Funds: August A Dress Rehearsal, Volatility Expansion Imminent

Article in EQDerivatives

Tuesday, September 15, 2015 — 6:41 PM BST

Last month, the Newedge Volatility Trading Index returned 1.07%, its highest performance since October 2014. Long vol (2.04%) and tail risk vol (4.64%) averaged positively during the month, while relative value vol (-2.26%) and short vol (-3.43%) averaged negatively, according to the CBOE Eurekahedge volatility hedge fund indices.

The performances came during a month where China’s stock market came under increased pressure, culminating in ‘Black Monday’ that led to the Shanghai Composite Index falling more than 8%. It sent shockwaves through the global equity markets, with substantial moves being seen in equity vol in Europe, while S&P 500 skew and convexity exploded.

With the spike in vol of vol came increased opportunities to trade gamma, while what vol funds consider ‘fear’ failed to materialise. Neale Jackson, portfolio manager at tail risk volatility fund 36 South Capital Advisors in London, noted that August therefore acted as a dress rehearsal for an expansion in volatilities. Three of 36 South’s strategies [gained] in August where gamma trading drove the majority of positive returns.

“There was gamma in the market but no real fear, it’s the fear that really causes the expansion in volatilities as people are prepared to pay an unreasonable price for protection. Now, nobody was prepared to pay unreasonable amounts for protection because the fear was not there. Convexity hasn’t really picked up and in terms of an absolute purist vol fund with a duration book of volatility instruments, developments in August didn’t even cause ripples yet, and in some cases there were vol drops, i.e. in the EUR/USD,” said Jackson. “So the expansion of volatility is really what we are looking for and August showed symptoms of what might come.”

Christopher Cole, managing partner at long vol fund Artemis, added there was a lot of built up hidden shadow gamma and leverage in the financial system. In a leaked investor newsletter, Artemis revealed its vega fund was up 18.11% before fees from Aug. 1 to Sept.1 including an estimated 2.27% increase in August. EQD reported this month that Artemis’ long vol tail risk strategy Artemis Vega Fund saw a one day gain of 15.49% gross of fees on Sept. 1.

“I think this is a full blown regime change and I think it’s going to get a lot worse before it gets better. Our pattern recognition models track systemic risk globally for crisis prediction and this isn’t looking good,” said Cole. “You have the Chinese government propping up their stock market; you have the [European Central Bank] expanding their program; on one hand the [U.S. Federal Reserve] is meant to be tightening, while on the other hand you have certain people talking [Quantitative Easing Four]. This is not a healthy dynamic.”

Pierre de Saab, partner and portfolio manager at Dominicé & Company Asset Management in Geneva, noted that the issues that emerged in August will likely be on the agenda in the coming months. Combine that with instability driven by the potential of money managers pulling the plug on risk as the end of the year approaches, it could lead to increased dislocations and subsequent opportunities for volatility funds. The firm’s relative value volatility fund Cassiopeia Fund returned more than 3% in August.

“There are some interesting things emerging. Firstly, based on the open interest in the VIX ETP market and our discussions with brokers, it appears a lot of long volatility investors have used the August volatility spike as an opportunity to unwind their positions and have not renewed their hedges.” said de Saab. “On the other end, many tactical players are shorting volatility now because it’s higher. Therefore, the net position of end-investors appears to be short vega and, as a result, the short-term implied vols of SPX is now coming in substantially. Secondly, the one-month implied volatility on major indices has come off from its peak and is currently lower than the realised volatility. This is typically what happens after a crash. However, unlike the past 2 years, when short-term volatility was coming down as quickly as it had gone up, the pace of the decrease is now slower. Also, the medium term implied volatility remains elevated.  These are signs that this latest correction was not the end game and that there may be a more volatile period ahead of us.”

China, a forthcoming hike in rates in the U.S. and Greece, as well as other E.U. countries, lurking in the background make a blend of volatility fund strategies attractive as a way of diversifying portfolio strategy. Jackson pointed to the response of the U.S. Federal Reserve to the effects coming from the crisis in China as a driver of an expansion of volatilities.

“The three currency devaluations by China certainly put the cat among the pigeons for a couple of reasons. There have been several websites that discuss China having chewed through quite a bit of their foreign reserves. If their foreign reserves are given a mark-to- market in Treasuries and they start to liquidate enough of those for cash to cause Treasuries to fall and yields to rise that in itself would be enough of a headache meaning swap lines would have to be created for the Chinese to use to defend their currency,” said Jackson. “There is no doubt in my mind that China has used up considerable ammunition defending those pegs. The creation of the swap lines will affect the treasury curve or invite QE4 since, if the Chinese actually need to liquidate there is only one way to liquidate that volume by having an equal buyer of that size. So certainly there is going to be pressure on the U.S. rates curve coming from China in order to sustain the peg, or they are going to have to let it go. Either way, there is going to be some extreme volatility to come.”

As an expansion in volatility appears on the horizon, institutional investors are responding by increasing their allocations to vol funds, with new entrants of allocators being reported. Volatility funds are seeing an increase in assets across multiple strategies and have told EQD of tickets between USD5-15 million in recent weeks.

“We are currently telling our investors this is the best environment we have seen in the last two years. Investors are moving away from the idea that they can invest blindly in equities because they hold a “free” put from the Fed or the European Central Bank. The price of risk and the volatility premiums are returning to levels that are actually closer to the median, which simply means that we’ll have more opportunities going forward,” added de Saab.

2015
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