KSW Multi Structure Fund – Volatility

Relative Value/Volatility Arbitrage – Runner-Up

Originally published in the March 2013 issue

Dr Oliver Schwindler, who received his finance phD from the University of Bamberg, believes that a dynamic approach is needed to avoid the risks of a purely short, or purely long, volatility approach. The almost complete capital losses incurred by some volatility exchange traded funds (ETFs) show how a long only volatility strategy can slowly but steadily lose investors’ money. Likewise even if a short only strategy is not wiped out by catastrophic losses, its volatility is likely to be far too much for most investors to stomach.

In between these two extremes, the objective of the KSW Multi Structure Fund – Volatility is to generate enough “income” from selling volatility with limited risk, to finance the opportunistic purchase of long volatility exposure that can provide big payouts during adverse market events. Timing is of the essence because “it is too expensive to own volatility all of the time” says Schwindler, who is the portfolio manager of the fund.  

The strategy is driven entirely by pre-defined, systematic rules and is designed to make profits both from going long of volatility, and going short of volatility on a strictly controlled risk basis. A set of proprietary indicators signal whether and when the fund should be long only, short only with capped risk, or run some combination of long and short positions. As indicators switch on or off, the fund can steadily transition towards more or less exposure. The fund becomes fully invested in the tail protect strategy only when all three indicators are signalling a tail event.

The tail protect strategy buys call options on the VIX index of implied volatility. The volatility premium strategy uses both directional and relative value approaches, including calendar spreads, to generate income. Trade structuring partly depends on whether the term structure is upward or downward sloping, as this influences whether roll yields are positive or negative.

Both the tail protect, and the volatility premium, strategies would be profitable on a standalone basis. The varying blend of the two has been most profitable in crisis months: September 2008, May 2010, and August 2011. The best performance from the latest three tail events came during September until November 2008, after Lehman collapsed, when the proforma performance would have been up by 58%.

For 2012, the fund returned 2.45% and was beaten into second place by the CCR Active Alpha Fund. Although volatility was declining for most of the year, the volatility premium strategy generated more than enough returns to cover the cost of paying away some premiums for protection. Unencumbered cash is invested in short dated Euro-denominated bonds issued by corporates and German federal states; German government bills with negative yields are avoided. The tens of basis points of coupon income from the bonds currently goes towards defraying management fees, but such income does not contribute returns at current levels of interest rates.

Risk management has many dimensions. First of all the UCITS structure chosen by Schwindler limits gross exposure to 100%, meaning that no leverage can be used. Additionally the fund purchases call options on the VIX index when it has short exposure. The back-testing process stretched back to the 1980s to stress test the impact of the 1987 stock-market crash. Although some market participants think the highest recorded VIX reading was 80 in 2008, in fact the VIX index went more than twice as high in 1987, touching 172. The fund only buys plain vanilla calls on the VIX and does not sell them. Only exchange traded instruments are invested in, with no OTC (over the counter) exposures, which minimises counterparty risk. The VIX futures market now has average daily volumes of more than 2 billion USD in notional terms.

Schwindler’s daily dealing fund was seeded with EUR 11.5mm by KSW Vermoegensverwaltung AG, a wealth manager based in Nuremburg. So far, this new fund, which launched in October 2011, has made a promising start, outperforming many larger and longer established ones in 2012.