Volatility specialists face year of rewards and reckoning

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Volatility returned with a bang last year, wrongfooting many investors but leaving traders that specialise in surfing the undulations of financial markets eagerly awaiting a new era of turbulence in 2019.

January started with a market melt-up that unravelled in dramatic fashion, when “ short-volatility” bets that everything would remain calm came unstuck in spectacular fashion. Two popular short-volatility funds were shredded, exacerbating the stock market turmoil and shaking investors from their torpor.

Markets regained their footing, but since October stocks have see-sawed lower, at one point sending the S&P 500 into an intraday bear market. The Vix volatility index jumped by 20 per cent or more a dozen times last year, something it had only done 24 times in the previous five, and 71 times in total since the “fear gauge” was born in 1990.

More intriguingly for volatility specialists, the turbulence has started to bleed out from equities and into other asset classes that until later in 2018 were relatively subdued.

“It’s been an interesting year from start to finish,” says Federico Gilly, a volatility fund manager at Goldman Sachs Asset Management. “As we’ve transitioned to a higher volatility environment it has affected different markets differently.”

Volatility traders like Mr Gilly typically use derivatives to profit from trends in turbulence itself, rather than traditional stocks or bonds. There are many ways to try to exploit volatility, from straightforward, systematic bets on turbulence or tranquility, to more tactical “relative value” strategies where traders buy protection in markets where risks are under-appreciated or sell it where other investors are too fearful.

Last year was not a banner year for volatility funds, as the periodic spikes of choppiness wrongfooted even many of the specialists — especially the “Volmageddon” spasm in February.

HFR’s index of relative-value volatility hedge funds was down 0.1 per cent in the year to November, while EurekaHedge’s equivalent fell 1.1 per cent. Volatility hedge funds with a bias towards betting on turbulence failed to profit from its outbreak, losing 4.4 per cent, while those with a tendency towards tranquility lost 8.1 per cent, according to EurekaHedge’s indices.

But many in the industry hope that 2019 will be the year when volatility traders — as opposed to those that simply sell insurance against it and pocket the steady premium from those buying it — will truly shine. For the expectations that this year will be even more turbulent are widespread.

“After years of relatively smooth sailing in the financial markets, heightened volatility is rocking the boat once again,” Capital Group, the $1.9tn mutual fund manager, noted to clients. “There are many factors, but the three Ts are among the most impactful: tightening monetary policy, trade tensions and too much debt.”

Benjamin Bowler, head of global equity derivatives research at Bank of America, argues that the “low vol bubble” that expanded in the post-crisis era is now deflating, and that many investors are still unprepared for a new more turbulent environment that is now beckoning.

“Looking at the world through the lens of volatility, we see markets that are unsustainably out of sync, fragile, and overall underpricing the risk of regime change,” Mr Bowler notes. “History strongly suggests that the market we see today won’t exist by the end of next year. While some markets have begun to ‘wake up’ to an inherently riskier world — less supported by central banks — many have not.”

Indeed, volatility traders say the new regime has now started to widen beyond equities to government debt, currencies, commodities and corporate bonds — albeit to varying degrees.

“The changing volatility dynamics started in equities but has migrated to other asset classes,” Mr Gilly says. “Credit was the last asset class to see higher volatility.”

Some remain sceptical that volatility will continue to broaden and deepen. For example, JPMorgan analysts predict that the Vix index — which reflects the US stock market volatility implied by options prices rather than the market’s actual volatility — will average around 15-16 points this year. That is well below the gauge’s current 28 level and broadly comparable to the post-crisis average.

However, they do expect more sudden bursts of volatility, akin to the turmoil seen in February and the final quarter of 2018.

“With higher interest rates, there are also rising structural risks, most prominently the decline of market liquidity,” argues Marko Kolanovic, head of quantitative strategy at JPMorgan. “Given the outcome of US midterm elections, it is virtually certain that US political divisions will introduce gridlock and additional market volatility in 2019, as will political issues in Europe.”

This will be tricky for traditional investors, which have become accustomed to the long period of central bank-assisted tranquility since the financial crisis. But also for volatility specialists, who will have to tread carefully in this new, less certain world with sudden bursts of turmoils pocketing quieter periods, to avoid mishaps and prove their credentials.

“We don’t know if we’re reached the end of the cycle,” Mr Gilly notes. “It is going to be a lot harder for volatility investors. We will have to take smaller positions and be more nimble.”

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