Volatility: A Blessing and a Curse for HFs

Date: Wednesday, April 16, 2008
Author: Emma Trincal, Senior Financial Correspondent, Hedgeworld.com

NEW YORK (HedgeWorld.com)—The spike in market volatility since the credit crisis hit the United States last summer is bad news for many hedge funds caught in the market's ups and downs. However, one type of hedge fund is likely to profit from the market's wild mood swings is the volatility arbitrage hedge fund. Yet, even for those experts, the current market turbulence is challenging.

Volatility arbitrage players protect themselves from opposite moves in the markets by trading a portfolio of options that is "delta neutral," a statistical term that refers to risk neutrality.

Delta neutrality simply means that managers trade options—calls or puts—on the long and the short side of the market. But their overall sensitivity to changes in the price of the underlying asset, or "delta," remains neutral. That way, the overall portfolio is hedged.

Volatility hedge funds are said to be well positioned in a volatile environment because they are long volatility; in other words, they gain from a rise in volatility. But even if this is true in general, things can be more complicated depending on the arbitrage.

Since August, the market has become highly volatile, with the Chicago Board Options Exchange Volatility Index, or VIX, swinging between 25 and 35. The index is around 25 right now. To put these levels in perspective, the VIX in the period from January 2004 to July 2007 averaged around 13.6.

Since last August when the credit crisis officially began in the United States, volatility has made a meaningful comeback. The question is, for how long?

Most experts agree that given recent events, including the Federal Reserve Board's bailout and negotiated sale of Bear Stearns, the fifth-largest investment bank, and the persistence of the credit crunch as more banks post losses each quarter, volatility will be a lasting market trend over the coming months or even years.

"Volatility is here to stay," said Paul Britton, chief executive of Capstone Investment Advisors, a volatility arbitrage hedge fund. He spoke at a conference on volatility arbitrage held in New York last week and sponsored by EDUnar Forum.

Some managers worry about the new volatile environment, since volatility means more uncertainty, and anyone can either lose or lose in a big way. Others, though, see future potential profits.

"It's going to be a very difficult road for a lot of hedge funds," said Robert Doherty, managing partner and chief investment officer at Doherty Advisors LLC, a $200 million volatility arbitrage hedge fund based in New York, in an interview. "But volatility arbitrage funds will flourish."

Mr. Doherty's fund did well so far last year posting a return of 9% and 15% for share class A and share class B, respectively.

But Mr. Doherty said that a lot of hedge funds face challenges right now because of their long equity bias—giving them beta close to 1—which makes them vulnerable to market shifts. If one adds to that picture the difficulty hedge funds face in selling assets that are hard to value and levels of leverage that remain too high, one can easily understand that volatility is not always a hedge fund's best friend.

"All these asset classes are going through this massive de-leveraging and re-pricing of risk and there are very few hedge fund strategies that are well positioned in this high-volatility environment," Mr. Doherty said during last week's conference. "Convertible arbitrage shops and long/short equity managers are not giving the desired results."

In an interview, Mr. Doherty explained why so many convertible arbitrage hedge funds are going through a rough time. The reason, he said, is because instead of being just long convertible bonds, they also have exposure to a lot of high-yield bonds or single-A corporate bonds that are "trading down and underperforming in this credit environment."

For the long/short equity hedge funds, troubles come from their long bias to the market, he said. And even if they try to adjust and increase their short exposure, he said they can easily get caught in a short-term rally that "wipes them out" in a matter of days.

In theory, all hedge funds, which by definition can be both long and short the market, should be able to make money in both up and down markets. But that's easier said than done.

Mr. Doherty said that since August the market has seen sharp swings that have been difficult to predict, including the turbulence last August when stocks fell sharply and then rose, followed by other down-and-up cycles in October-November and January-February. Finally, in March, Bear Stearns' near collapse precipitated a sharp sell-off followed by a market recovery after the Federal Reserve Board's March bailout.

"Just around March 17, the market plunged 10% but it's been back up 10% since then and until April 7," Mr. Doherty said. "You have people who were short and then got wiped out when the market came back. A lot of the hedge fund community has been getting whipsawed."

Reflecting the current level of fear and uncertainty felt by managers, James White, managing partner at Dallas-based convertible arbitrage hedge fund Excelsior Capital Management LLC, quoted one of his traders during last week's conference: "If you're in a world where everyone around you is losing their wits and you're not, it's quite possible that you don't know what's going on."

Even for volatility arbitrage hedge funds that specialize in the market's wild fluctuations, the game is not easy. In theory, because volatility arbitrage managers are long volatility, they pocket higher returns in a high-volatility environment. But this is an oversimplification because when prices move sharply, being long volatility also becomes more expensive. Those in a position to win are those capable of hedging their bets, said Mr. White in an interview. Mr. White, who spices up his convertible arbitrage strategy with volatility bets, said he takes a relative value approach to volatility arbitrage.

"Spikes in volatility are good for volatility arbitragers in general because there are just more opportunities to make arbitrages," he said. "But if you own volatility outright as an investment product, it's certainly more expensive. A long-only play is riskier and you're much better off trading volatility in a relative value play."

Mr. Doherty predicted that the market will remain at a "highly elevated" level of volatility, with the VIX staying in the 25 to 35 range for the next 12 to 18 months. After that, the market will continue to be volatile with a VIX in the 28 to 30 range for the next two to three years, he said.

Despite the higher cost of volatility trading, the spike in volatility should be good for volatility arbitrage hedge funds, because those managers are better positioned than others to hedge their risk exposure, Mr. Doherty said.

"Hedge funds that will succeed in this environment need to find a strategy that can prosper in a quickly expanding/contracting volatility cycle," he said. "They have to be liquid enough to always remain nimble. And they must reduce leverage. A 10-to-1 or 20-to-1 leverage today is a recipe for disaster."

Mr. Britton agreed that "volatility is here to stay." He added that leverage is one of the things that keeps him up at night as a volatility arbitrage manager. "Everybody is trying to get rid of beta and they can't do it quickly enough. People are trying to adjust their correlation to beta but it won't happen overnight. The door is too small for all to get out," he said.

ETrincal@HedgeWorld.com