Research

Volatility investing hedge funds are a much overlooked segment of the hedge fund industry - niche players who invest exclusively in volatility as either a standalone alpha generating strategy or as part of a diversified portfolio seeking to provide downside protection during periods of elevated market stress. The strategy though is ripe for a comeback, and a source of much added value for investors seeking to hedge their portfolios during uncertain times and possibly flirt with the notion of direct exposure to volatility as an asset class in its own right. The report which follows will review the performance of the CBOE Eurekahedge Volatility Indexes over the years and the added benefits that can arise from increasing allocations towards volatility investing strategies.

The CBOE Eurekahedge Volatility Indexes are a set of equal-weighted indices which track the performance of underlying hedge fund managers who invest exclusively into volatility as an asset class. The CBOE Eurekahedge Volatility Indexes comprises four equally-weighted volatility indices – long volatility, short volatility, relative value and tail risk. The CBOE Eurekahedge Long Volatility Index is designed to track the performance of underlying hedge fund managers who take a net long view on implied volatility with a goal of positive absolute return. In contrast, the CBOE Eurekahedge Short Volatility Index tracks the performance of underlying hedge fund managers who take a net short view on implied volatility with a goal of positive absolute return. This strategy often involves the selling of options to take advantage of the discrepancies in current implied volatility versus expectations of subsequent implied or realised volatility. The CBOE Eurekahedge Relative Value Volatility Index on the other hand measures the performance of underlying hedge fund managers that trade relative value or opportunistic volatility strategies. Managers utilising this strategy can pursue long, short or neutral views on volatility with a goal of positive absolute return. Meanwhile, the CBOE Eurekahedge Tail Risk Index tracks the performance of underlying hedge fund managers that specifically seek to achieve capital appreciation during periods of extreme market stress. Historical returns for the indices along with constituent details can be accessed here.

Figure 1 shows the performance of various volatility investing hedge fund strategies along with monthly gains/losses for the S&P500, Eurekahedge Long Short Equity Hedge Fund Index and the Long Short Equity 20 Index¹. The year started off on a sour note with weakness in Asia and declining energy prices leading markets lower, with the CBOE VIX Index (measuring 30 day implied volatility on SP500 futures contracts) climbing almost 11% in January. The S&P500 and the Eurekahedge Long Short Equity Index declined 5.07% and 1.78% respectively during the month, while strategies with a net long view on implied volatility saw strong gains – Long Volatility and Tail Risk strategies up 2.75% and 3.48% respectively. As markets somewhat calmed down in the months leading up to Brexit, the momentum shifted from long volatility to relative value volatility strategies (opportunistic trades on volatility) and short volatility strategies which were up 5.20% and 3.48% in the February 2016 to May 2016 period while the Eurekahedge Long Short Equity Hedge Fund Index and the S&P500 were up 2.54% and 8.08% respectively.

Meanwhile Tail Risk strategies saw the steepest decline over this period, down 7.36% in the four months up to May as the VIX plummeted by almost 30%. June followed with the Brexit shock, which did not work as well as expected for long volatility and tail risk strategies as markets were quick to digest the news and volatility levels as depicted by the VIX subsided. Long volatility strategies posted modest gains (up 0.89%) while tail-risk strategies declined 3.29% following the sharp reversal in volatility. In the relative calm that has quite surprisingly followed Brexit, short volatility strategies have stood to gain, up 2.16% in July 2016 to August 2016 as fund managers have harvested premiums through option underwriting – protection that was sought post Brexit against another potential spike in volatility. As of August 2016 year-to-date, relative value volatility strategies are in the lead among the volatility sub-group, up 6.36%, and ahead of the S&P500 which is up 6.21% and the Eurekahedge Long Short Equity Hedge Fund Index which has gained 2.76% over the same period.

Figure 1: Volatility investing strategies in 2016

Figure 2a depicts the four CBOE Eurekahedge Volatility Index sub-strategies against the backdrop of the CBOE VIX Index. The chart serves to emphasise two important points:

1. There are multiple routes to gaining exposure to volatility as an asset class for investors as depicted by the distinct stream of returns from the volatility sub-strategies utilised by hedge funds since 2007. The CBOE Eurekahedge Relative Value Volatility Hedge Fund Index by far offers the smoothest and most consistent stream of returns, but that would not be to understate the role of short-volatility or long volatility and tail-risk strategies in an investor’s portfolio given their unique plays on volatility.
   
   
2. Volatility is mean reverting, punctuated by steep spikes and drawdowns with plenty of noise which makes a passive strategy a difficult buy for investors.

Figure 2a: Volatility investing strategies and CBOE VIX

Figure 2b depicts long volatility and tail risk strategies against the backdrop of traditional equity long short hedge fund strategies and the S&P500. Tail-risk strategies operate under the goal of providing protection during periods of extreme market stress, while long volatility is an alpha generation strategy that as depicted below minimises the ‘bleed’ much more effectively during periods of depressed market volatility.

1. Long volatility hedge funds have delivered the best gains since 2007, outperforming the S&P500 and traditional long short equity hedge fund strategies. As can be easily spotted in the figure below, the year that made the difference was 2008 when the CBOE Eurekahedge Long Volatility Hedge Fund Index gained 45.81% while the S&P500 and long short equity hedge funds sank 38.49% and 9.74% respectively.
   
   
2. Tail risk strategies remained ahead of the S&P500 till end-2012, following which the sustained decline in implied volatility as depicted by the CBOE VIX drained the strategy. However if the recent uptick in volatility and the adage ‘the calm before the storm’ are any indication, a pay-off could be long overdue.

Figure 2b: Long volatility and equity strategies

The detailed risk-return metrics for the volatility indices along with those for the CBOE VIX and equity strategies can be seen in Table 1. Over both the five and eight year periods based on annualised returns, relative value volatility hedge fund strategies have posted the best Sharpe ratio – 1.46 and 1.67 respectively. In the past two and three year periods, they come in a close second after traditional equity long short strategies.

Table 1: Historical returns for volatility strategies

A couple of key points should be noted from the correlation matrix show in Table 2 below.

1. As can be expected, both hedged and traditional equity strategies have much to gain from diversification across long volatility and tail risk strategies given their negative correlation to the former. Both volatility strategies can be vital to smoothening returns and improving the overall risk-return profile for an equity portfolio.
   
   
2. Short volatility strategies are positively correlated to both traditional and hedged equity strategies, though it is pertinent to note that long/short equity strategies correlate more strongly (0.801) to underlying markets (as depicted by the S&P500) while the correlation is relatively weaker for short volatility strategies (0.540). Hence adding short-volatility exposure to a traditional or hedge fund equity portfolio can yield beneficial effects vis a vis risk-return profile for the portfolio.
   
   
3. Relative value volatility strategies have small-to-moderate positive correlation to the S&P500 and equity hedged strategies while being negatively correlated to long volatility and tail risk strategies. In the pool of indices depicted in the table below, they correlate most strongly with the short volatility strategies. It could thus be fair to presume that the average relative value volatility hedge fund takes a net short view on implied volatility more often (as opposed to net long implied volatility), which in world where volatility spikes happen less frequently would be the sensible side of the trade to be on – mostly.
   
   
4. Tail risk strategies, as expected are positively correlated to the long volatility strategies, though not very strongly given the difference highlighted between the two earlier. They correlate negatively to all volatility and equity strategies -0.619 versus the short volatility strategies given their opposing bets.

Table 2: Correlation matrix

Next we add on the underlying constituents for each of the volatility sub-strategies, using an equal weighted approach, to the Long Short Equity 20 Index to visualise the gains accruing to a hedged equity portfolio. Figure 3a shows the addition of long volatility hedge funds to the Long Short Equity 20 Index – with the return smoothening and reduction in drawdowns quite apparent. Given the bull run of 2013 however, the standalone Long Short Equity 20 Index has fared relatively better.

Figurea 3a-3d: Long Short Equity 20 Index plus volatility strategies

Figure 3b shows the addition of short volatility hedge funds to the Long Short Equity 20 Index – given the strong positive correlation between the two, the gains are not as apparent here though the drawdown in 2008 is slightly shallower.

Figure 3c shows the addition of tail risk to the Long Short Equity 20 Index – the most noticeable observation is to be made is for 2011 when adding a tail-risk exposure improves returns by 5.78%. However, the bleed inherent to a tail-risk protection strategy does take its toll on the equity hedged portfolio. It should be noted that an equal weighted approach has been adopted in this analysis which overweighs tail risk in an equity hedged portfolio, and thus an asset weighted optimisation approach would yield better results once a limited portion of the portfolio is dedicated to tail risk strategies – like a massive insurance policy that pays out when financial markets suffer from steep drawdowns.

Figure 3d shows the addition of relative value volatility strategies to the Long Short Equity 20 Index – with the performance smoothening quite evident as depicted below. More on this with reference to Table 3 which follows shortly.

Putting the above charts into numbers, table 3 shows the overall impact on risk-return over the period under analysis. Some key takeaways:

1. Over the last three, five and eight year periods, the combination of relative value volatility hedge funds to a portfolio of 20 equity long short strategies has yielded the best Sharpe ratio among the lot – 1.50, 1.76 and 1.56 respectively.
   
   
2. Over the last two years, the addition of long volatility strategies to our equity hedge portfolio has yielded the best risk-return profile, two year Sharpe ratio of 1.15. This given the recent bouts of market volatility would be something to take stock of.
   
   
3. Overall portfolio volatility levels have generally declined with the addition of volatility sub-strategies to an equity hedge portfolio, with this reduced volatility in some cases resulting in a drag on returns for the Long Short Equity 20 portfolio.

Table 3: Performance numbers – Long Short Equity 20 Index plus volatility strategies

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