Some observers have suggested that the closure of the short volatility ETN, XIV, marks the end of short volatility trades. Most of the short-only volatility ETNs or ETFs have lost around 90% in the first two months of 2018. Meanwhile, the long-only versions are up 40-50% in 2018, but have often lost over 99% over a number of years, which illustrates the persistency of the volatility risk premium.
Strategies that short volatility on a limited risk basis (generally using spreads or tail hedges to cap downside) have incurred some losses in 2018, but generally less than what they made in 2017. These include a number of UCITS funds that have won our UCITS Hedge performance awards.
Such strategies can be invested in independently, and increasingly they are components of the growing range of “alternative risk premia” or “alternative style premia” products, which may be diversified across three or more sources of risk premiums, including momentum, mean reversion, value, and carry across multiple asset classes. ARP strategies charge higher fees than most ETFs, but lower fees than most hedge funds.
The incentive structure is what distinguishes hedge funds from ETFs and ETNs. Hedge fund managers are personally invested, and earn performance fees, which means they have “skin in the game”. ETF providers earn management fees and it is not clear whether those structuring them have any personal exposure. Credit Suisse issued a statement saying it had no net exposure to XIV, for instance. Banks may need to retain exposure to securitised credit, such as mortgage pools, under risk retention rules, but are apparently not compelled to eat their own cooking when it comes to ETFs.
Volatility hedge funds have better track records than either long-only or short-only volatility ETFs/ETNs. For instance, the CBOE Eurekahedge Short Volatility, and Long Volatility, Hedge Fund indices have both profited since inception in 2005. One seasoned volatility hedge fund, Capstone, was reportedly short of the XIV ETN!
The best volatility hedge funds have performed well in high and low, and in expanding and contracting, volatility climates. Rather than just expressing directional views on volatility, they may be trading the term structure, skew and spreads within and between geographies, venues, instruments and asset classes. Hong Kong-based True Partner Capital (the last hedge fund seeded by IMQubator, where I worked between 2011 and 2013) made 21% in February 2018.
Hedge funds may need a strong suite of counterparty relationships to access some of the more exotic and customised volatility instruments, but a growing variety of volatility products now trade on exchanges such as CME Group, CBOE and Eurex. This makes it easier for more hedge funds, and style/risk premia funds, to add a volatility string to their bow. At the same time, many other hedge fund strategies may find that heightened market volatility increases their opportunity set.
Editor’s Letter – Issue 130
Originally published in the March 2018 issue