Putting market volatility to work

Persistent high volatility across the world’s stock markets has been a big driver in shaping product development, both the growth of structured products to limit downside risk, and also the emergence of volatility as an alpha-generating asset class in its own right. The structured product market developed partly as a response to the dotcom collapse of 2000, and has by and large delivered on its promises. “We saw a lot of structured products launched in the aftermath of the 2000-03 bear market which had as their main feature capital protection,” says Hassan Houari, head of equity derivatives structuring at Barclays Capital. “Now investors have seen a boom and bust twice over, many are pleased with structured product performance and are willing to reinvest money from maturing products into new capital protected products. These structures have outperformed traditional asset classes which have performed badly over the last few months.” Structured products can have drawbacks regarding liquidity, however, and investors are currently reluctant to be gated. An interesting development in the last few years has been options where the payoff is not only linked to the value of the underlying asset at maturity, but to the realised volatility of that asset during the life of the trade. Barclays Capital has seen huge interest in a product called Revolver, a variation of the volatility target option. This strategy targets a specified level of risk on the underlying and gives exposure based on the observed risk in the market. When the underlying exhibits lower risk then Revolver gives higher exposure and when the underlying shows bigger risk, such as in a downturn, Revolver reduces exposure. It has consistently outperformed the market, cutting beta losses by a factor of two. Due to the managed risk profile, the options can be 30-50 per cent cheaper than a vanilla call on the same asset. A product originally designed to deal with the high volatility of emerging markets, Revolver is now used for a variety of asset classes, and is sold across Asia and Europe, and in the UK, under the brand Optimiser. An investment bank will often arrange a structured transaction for an ultra high net worth client, and subsequently list it on an exchange to broaden access to a wider client base. Protecting capital Demand for partial capital protection has grown this year. For example, Barcap offers an 80-90 per cent capital protection product, called Prosper, a daily portfolio protection mechanism. Rather than protecting a defined value at maturity, it protects a predefined percentage of the highest value ever achieved by the structure. On the alpha generation front, some of the purest trading on volatility involves the Chicago Board Options Exchange Volatility Index, known by its ticker VIX, an implied volatility index that measures the market’s expectation of 30-day S&P 500 volatility as revealed in options pricing. However, products playing on the VIX are a limited universe. Trading options on the VIX to capture movements in the S&P 500 is the popular strategy, taking advantage of the characteristic that the VIX’s implied volatility is always greater than its actual volatility, which means that traders and hedge fund managers who consistently sell the index generally have the wind behind their sails. There is strong demand from high net worth clients for a wide range of volatility trackers and swaps. Claude Schmidt, European head of equity & commodity risk management/investments for key clients and family offices, at UBS Investment Bank in Zurich, says clients are using a wide range of instruments, particularly volatility swaps to short volatility in crude oil and natural gas. Natural gas has a particularly interesting seasonal future curve pattern. “Using a commodity as the underlying for volatility instruments is the newest trend,” says Mr Schmidt. “Volatility instruments are becoming more and more popular and are a true additional asset class. As a general trend we see commodities are becoming an underlying for any kind of investment strategy. As more investors invest in commodities, liquidity is increasing too. Commodities are not just used to diversify or as an inflationary hedge but because investors expect returns in a reasonable ratio to risk. For instance clients who think the market will stabilise can use short volatility swaps to take advantage of the market becoming calmer.” Wider scope Hedge fund managers are also broadening the range of assets they play. Aaron Schindler of Hartland, US-based Schindler Trading says: “We take long and short positions in a dozen different global futures markets: stock and bond indices, currencies, and gold. We try to capture the frequent retracements or bounces after sharp moves, typically holding our positions for one to three days. “We’ve always used this same, fully-automated, trading strategy but in response to recent market volatility we’ve added gold to the mix. For years the gold market was the rather dull province of Indian brides and gold-bug doomsayers, but with global quantitative easing and rising inflation worries the gold market has become much more active and volatile.” Another common adjustment to trading patterns has been position-sizing calculations. “The number of futures contracts we trade at a time is inversely proportional to the recent volatility in the market, ie twice as much volatility means we’ll trade half as many contracts,” adds Mr Schindler. “This method of position-sizing tends to keep our profit potential and downside risk constant regardless of market volatility. In every market we trade, the volatility is higher than it was a year ago and we are trading smaller positions. Volatility actually works in our favour here because by trading fewer contracts our investors pay less in commissions and enjoy a slight boost in their returns.” Volatility as an asset class offers the attraction of a strong negative correlation with equity markets, and this can be explicitly packaged. SGAM offers three funds linked to volatility, each with a specific alpha return – anti-correlated to equities, de-correlated to equities and correlated to equities. Currently, the most popular is the anti-correlated fund which rose 18.85 per cent net of fees in 2008, according to Bernard Kalfon, volatility arbitrage fund manager at SGAM Alternative Investments. SGAM’s volatility funds do not get involved in illiquid underlyings, such as individual stock options or Var swaps, but instead use options on the big indices, major currencies and major bond markets, as clients are looking for a high degree of liquidity and transparency, and are currently finding it difficult to read the markets. “Caution is a popular word at the moment,” agrees Dan Draper, global head of ETFs at Lyxor. “Investors are not looking at specifics such as growth or value or large or small caps but are just looking to catch the bounce. Volatility is so high and it is hard for investors to tell the difference between companies so they are simply buying the biggest benchmark or index they can.” Balancing act Many hedging strategies provide some degree of market neutrality, but balancing investments among carefully researched long and short positions specifically to provide an overall net market neutral position has become more popular. Alexander Barry, head of asset management sales at JPMorgan Asset Management, reports huge interest in market neutral funds. These funds can also be pound or dollar neutral, market cap neutral or style or industry sector neutral. Different houses use a variety of solutions from proprietary trading systems to traditional fundamental stock-picking. JPM has a majority share in hedge fund Highbridge, which returned 12.7 per cent last year with its market neutral Sicav, invested in the 1500 most liquid US stocks. BlackRock and Cazenove also have market neutral funds covering the UK market and Gartmore is launching one on the European market. Yield enhancement solutions have proved popular as interest rates dived. Historically, trading dividends has been restricted to the OTC dividends swap market. But some banks are offering principal protected notes which pay investors an annual coupon linked directly to the amount of dividends paid by companies within certain indices in the course of the year. Notes with a 5 year maturity have been popular as implied dividends even in the longer term have been depressed recently. In the US, where the options market is more mature, ETF holders are making extra income by selling covered calls, primarily on the S&P 500 tracker, the SPDR, but also on the Russell 200 to exploit the high volatility of smaller companies.

Hassan Houari