Since launch in June 2015, the Nomura Equity Volatility Risk Premium (“NEVRP”) daily-dealing UCITS strategy has seen the best of times and the worst of times.
Its 2017 performance of 24.9% and volatility of 5.35%, delivering a Sharpe ratio of 4.65, earned it The Hedge Fund Journal’s UCITS Hedge 2018 award for best risk-adjusted returns in the volatility arbitrage category. And early 2018 has provided a useful stress test for the strategy. As the VIX spiked to 50 on Monday, February 6th, NEVRP saw a loss of 23%, which was mostly implied mark to market related. (This was consistent with Nomura’s own, internal stress tests). The following day, performance bounced back by 21%, as the VIX settled back down in the 20s. After the February 2018 drawdown, Nomura garnered some inflows from investors who judged that the surge in volatility provided an opportune moment to invest.
The Fund was also tested within months of its launch. In August 2015, the sudden spike in volatility cost it around 13%, and this had been recovered by early 2016. Clearly, the return profile is correlated with equity and credit markets, but Nomura argue that it can recover drawdowns more quickly than a long-only holding in conventional asset classes.
Nomura view the gap between implied and realised volatility as a persistent risk premium, akin to an insurance premium embedded in the price that options trade at, which can be harvested. “Historically there has been a positive pick up between implied and realised volatility around 80% of the time,” says Jean-Philippe Royer, Chief Executive Officer at Nomura Alternative Investment Management, Europe Limited (“NAIM”). The strategy is not designed to be vega neutral, but it is not taking a directional view on the level of implied or realised volatility either. Rather it just seeks to extract the difference between the two. This is a plain vanilla strategy, which is not expressing views on skew or term structure, on differences between regional volatility markets, trying to pick optimal strikes or delta hedging at optimal points in the day by gamma trading, arbitraging OTC against exchange traded instruments, or a whole host of other volatility strategies. Nor is it trading volatility across multiple asset classes or equity indices – it only trades volatility on the S&P 500 US equity index. (Royer doubts whether adding European equity volatility would provide much diversification and finds Asian equity volatility markets to be less liquid).
Nomura are confident that structural forces should ensure that the volatility risk premium is here to stay. Regulations such as Basel III and Solvency II, both reduce the supply of volatility protection – and increase demand for it. “It is more costly for market makers to warehouse the risk now, due to regulatory changes, which also force more investors, such as pension funds and insurance companies, to buy portfolio insurance,” explains Royer. If some of the larger pension funds may be willing to implement a volatility strategy on their own, those who cannot could consider the Nomura strategy.
Various types of volatility risk premiums (and other sources of risk and return) can be accessed through different volatility instruments and strategies. Nomura argue that variance swaps provide one of the cleanest, purest and simplest ways to pursue their objective and believe that alternative approaches – such as shorting VIX futures or selling delta-hedged options – are not ideally suited to harvesting volatility risk premiums.
Shorting VIX futures was the strategy pursued by the exchange traded note (ETN), with ticker XIV, that was closed down by issuer Credit Suisse. For some observers, the demise of XIV is sufficient to rule out the strategy of shorting VIX futures, though a handful of other short volatility ETNs/ETFs still exist, generally down around 90% in the first two months of 2018.
In fact, a more sophisticated strategy of shorting VIX futures need not be doomed to blow up, if tail risks are hedged by, for instance, owning call options on the VIX future. Nomura identifies other issues with shorting VIX futures that complicate the trade however. “It is not a pure play on implied minus realised volatility. It is a strategy on the shape of the VIX futures curve,” points out Royer. A steepening, flattening or inversion of the term structure can change the optimal way of implementing the strategy, and require more trading and portfolio adjustments.
Selling delta-hedged options is also more complicated than it may sound. “It is in practice impossible to continuously hedge, meaning that some gap risk is being taken. It is also operationally complex, as the delta hedges need to be adjusted, daily or intraday, and throughout the volatility surface, and is prone to optimised backtests” explains Royer.
The variance swaps strategy is conceptually simpler and purer, but not entirely without its own complexities. For instance, Nomura diversifies its portfolio of variance swaps over multiple strikes and maturities, partly to avoid the ‘pin risk’ of having a concentrated exposure to a particular strike or maturity. The strategy thus owns a matrix of overlapping variance swaps positions between one day and two months ahead, at a ladder of strike prices, with a systematic daily implementation. “They are held to expiry to capture the difference between realised and implied volatility in a disciplined approach, which also reduces transaction costs, unless they need to be sold to meet redemption requests.”
Additionally, operational routines and best execution were challenges when Royer had experience of directly implementing a similar strategy: “we ended up with a big portfolio of variance swaps, which was resource intensive in terms of infrastructure, IT, and risk management. Using a QIS provider such as Nomura brings benefits: it avoids a lot of this operational burden without compromising on the quality of execution,” he says.
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