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European Market Turmoil Makes Volatility Traders First Among Hedge Funds


Date: Wednesday, August 3, 2011
Author: Jesse Westbrook and Jeff Kearns, Bloomberg

Hedge funds that ignore the direction markets move in to make their money have been almost the only ones to profit in Europe this year as their competitors racked up losses on commodities, banks and Europe’s debt crisis.

Hedge funds that use options to bet on fluctuations in the price of securities, known as volatility funds, climbed 5.1 percent in 2011 through June, according to the Newedge Group SA’s Volatility Trading Index. Every other strategy tracked by the Paris-based brokerage -- including macro funds that wager on broad economic trends and firms that invest in oil and metals -- lost money in the first six months of the year.

“The system is confused, and that’s evident in the returns,” said Michael Corcelli, managing member of Alexander Alternative Capital LLC, a Miami-based hedge fund that invests in equity-index options and other derivatives. “There are so many ways to make money playing volatility, and volatility systems typically perform best when everyone else is confused.”

The niche funds use options on stocks, currencies, commodities and other assets to try to profit from pricing discrepancies and the magnitude of price swings. The strategy has enabled some firms to profit when rivals have been roiled by shocks such as the stock plunge after Japan’s earthquake, oil’s drop in May and the risk of a potential Greek default.

Newedge’s index of volatility traders includes 10 funds that manage a combined $4.6 billion. The total number of volatility specialists, including funds that aren’t tracked by the broker, is small compared with the broader $1.8 trillion hedge-fund industry, said James Skeggs, the London-based head of Research in Europe for Newedge.

‘Complex in Nature’

“Volatility strategies are fairly complex in nature, and there are few people who have the necessary experience to run and risk manage these portfolios,” Skeggs said.

John Paulson, founder of the $37 billion Paulson & Co. fund, told investors last month that difficulty predicting how European leaders would respond to the region’s financial woes and the debate over extending the U.S. debt ceiling contributed to the 18 percent loss in his biggest pool this year, according to two people familiar with the matter who declined to be identified because the returns aren’t public.

Billionaire trader George Soros said at an April conference that he finds the “current situation much more baffling” than after Lehman Brothers Holdings Inc. declared bankruptcy in 2008.

Volatility traders say they aren’t baffled by their performance this year.

‘Fantastic’ Performance

“We didn’t have an exceptional first half of the year, but in the current environment, it was fantastic,” said Michel Dominice, co-manager of Dominice & Co.’s $410 million Cassiopeia Fund, a volatility fund based in Geneva, Switzerland that gained about 10 percent through June.

Volatility funds gained attention during the 2008 financial crisis when the firms posted an average gain of 3.2 percent, as the broader hedge funds industry posted its worst-ever annual loss of 19 percent. The specialist funds fell 2 percent in both 2009 and 2010 as market gyrations declined. Hedge funds were up 20 percent in 2009 and 10 percent last year, according to Chicago-based Hedge Fund Research Inc.

Dominice’s Cassiopeia Fund has made money every year since it opened in 2004, posting a cumulative gain of about 147 percent. The fund manager doesn’t expect trends in financial markets to get any clearer in August or September. Volatility may surge in October, as investors seek to exit money-losing trades before the end of the year and Europe’s sovereign debt woes re-emerge, he said.

‘Will Get Worse’

“Things will get worse in Europe as the problems potentially spread to Italy, and German taxpayers start to object to paying for the bills of Southern Europe,” he said.

His fund bets on discrepancies between the values of volatility indexes and futures on those indexes to try to take advantage of a view that markets have misjudged stock prices. As a hedge against losses, Cassiopeia then makes a bet that the stock market will either rise or fall.

Other volatility specialists that have profited this year include Paul Britton’s Capstone Investment Advisors LLC, which manages about $1.2 billion. The firm’s hedge fund gained 4 percent in July, bringing returns for 2011 to more than 10 percent, according to an investor who declined to be identified because the returns aren’t publicly disclosed. Jeremy Heckerling, Capstone’s general counsel, declined to comment.

VIX Index

Volatility in itself hasn’t been why the funds have profited: The VIX, as the Chicago Board Options Exchange Volatility Index is known, gauges investor expectations for price swings in the Standard and Poor’s 500 Index and the cost of using options to protect against stock declines. It averaged 18.04 in the six-month period ending in June, peaking at 29.40 on March 17 after Japan’s earthquake and closing at a low of 14.62 on April 28.

The VIX has averaged 20.34 over its 21-year history. The index reached a record intraday high of 89.53 in October 2008 after Lehman failed and the credit crisis triggered a selloff for stocks.

With volatility muted, firms have had few opportunities to make directional bets that price swings will either increase or decrease in magnitude, said Julia Kung, a Paris-based investment specialist at Amundi Asset Management.

“For there to be another shock in volatility would require something to happen that is unknown today,” she said. “The risk of a Greek default is something that is known in the market.”

Volatility of Volatility

The volatility of volatility itself has helped the funds. The 30-day implied volatility for VIX options surged 84 percent last week to a 14-month high of 128.52. That’s in the 98th percentile for all readings since VIX options began trading five years ago.

Hedge funds that make directional bets on stocks and commodities are creating volatility by changing their positions more frequently amid increasing uncertainty about the global economic recovery, said Stephen Yashar, chief investment officer of New York-based Cosyne Capital Management LP.

“The increase in the volatility of volatility is giving us opportunities to create new positions and unwind old ones and that’s great for traders,” said Yashar, whose hedge fund makes relative-value bets on stock volatility and has gained 11 percent this year.

To contact the reporter responsible for this story: Jesse Westbrook in London at jwestbrook1@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net.