True Partner: Volatility Arbitrage and Tail Risk

Helping investors adapt to the new market paradigm

Hamlin Lovell
Originally published on 22 September 2022
  • Above: Winter Landscape, Jacob Isaacksz van Ruisdael, c. 1665

Investors are rethinking their portfolio diversification assumptions after equities have started 2022 with the worst first half of a year in decades, while government bonds and corporate credit have also posted double digit losses. Unprofitable and long duration growth assets have seen the steepest drops, but higher interest rates are challenging, repricing and recalibrating all assets – including private equity and venture capital valuations – at a time when inflation raises the bar for real returns. 

Many institutional investors are re-examining how volatility strategies could complement portfolios, adapt to the new paradigm and help meet a diverse spectrum of investment objectives and constraints. Customisation is in particular focus as different investors have various tolerances for portfolio losses under different sorts of correction, crisis, crash and tail risk scenarios and also have different budgets for any ongoing portfolio insurance costs in normal climates. This influences at what levels of market setbacks they would seek to partly or wholly monetize hedges. Customisation can allow investors to define parameters around these variables and devise a good fit for their portfolios, strategies and platforms. Regulatory and fiduciary constraints for pension funds, insurance companies, endowments and foundations can also be factored into the architecture.

We’ve been doing this for long enough to know that diversification is the only free lunch, and that extreme scenarios sometimes become reality.

Tobias Hekster, Co-CIO, True Partner Capital

“Customisation lets investors tailor hedges to their worst scenarios for various asset classes. For instance, a recessionary slowdown would benefit bonds and hurt commodities whereas an inflation spike would do the opposite,” says Tobias Hekster, co-CIO at True Partner Capital, based in Chicago.

Hekster and the other founders of the firm have been active in equity options for the last two decades, in Europe, the US and Asia, initially for proprietary trading houses and market makers, before they set up True Partner. Its flagship relative value strategy was launched in 2011, a long volatility biased strategy was rolled out in 2016, and now a suite of customized offerings is a natural and logical evolution of the firm’s mission to deliver alpha for investors. With $1.7 billion in assets under management as of July 2022, the firm is one of the largest and longest established players in the volatility space.

Veteran volatility managers 

Multiple solutions are on offer. Experienced equity volatility managers who have navigated a variety of bullish, bearish and flat market and volatility regimes are increasingly sought after. Investors with global portfolios want to access equity volatility markets in the US, Europe and Asia around the clock to take advantage of dislocations, anomalies and inefficiencies within and between markets, inside and outside normal market trading hours. Seasoned portfolio managers who have previously worked as market makers and proprietary traders understand the incentives and motivations of those on the other side of the trade. 

Winter Landscape, Jacob Isaacksz van Ruisdael, c. 1665. Dutch Master Jacob van Ruisdael depicted this Winter Landscape towards the end of the Dutch Golden Age. Investors nowadays have more sophisticated financial tools at their disposal to brave the upcoming storm.

Options should not be seen as a zero-sum game, because they are only one part of portfolios. Different market participants are using options to achieve different objectives in their portfolios: some are enhancing income while sacrificing some upside and others are truncating downside, without necessarily seeking an absolute return from the option component in isolation. In contrast, those who are purely or primarily trading options view the whole volatility surface through their own analytical prisms.

Veteran volatility managers also have the software to model option portfolios’ multi-dimensional and dynamic risk profiles, and the wherewithal to employ and manipulate gargantuan repositories of historical data.

Instruments and implementation 

Customisation at the level of individual investment instruments can entail exotic, esoteric over the counter (“OTC”) instruments, which might be difficult and subjective to price and sometimes harder to trade, but these qualities are not inescapable features of bespoke volatility strategies. It is possible to use only liquid, exchange listed, standardized, and easy to price volatility instruments to construct customized mandates that avoid operational complexity, counterparty risk and potential illiquidity.

The liquid volatility space is highly unusual in exhibiting counter-cyclical liquidity: volumes traded tend to increase in a crisis precisely when liquidity can be evaporating or intermittent in some other markets. Whereas OTC option market liquidity can become impaired, liquid and listed options allow for rapid monetization, not least because market makers are obliged to continue providing quotes in certain key parts of the market. In addition, some investors, or automated hedging programs, tend to buy more insurance after panics, whereas a well-designed volatility program could well be moving in the opposite direction and cashing in on well-bid protection at these times.

Furthermore, customized option mandates can be structured in a capital efficient manner as the inherent leverage of options contracts also allows for large notional exposures with limited cash outlays, often via managed account structures, potentially freeing up capital for other parts of portfolios.

Balancing tail risks and relative value

A simple approach of buying put option protection is generally expensive because implied volatility is usually above realized volatility – and this was true for US equities even in the first half of 2022, surprising many investors. A “naïve” or simple put protection strategy might well have lost money over this period. For instance, the PPUT Index – which combines long equities with 5% out of the money put options – offered no real protection in the first half of 2022. As of mid-June 2022, it had lost about 25%, approximately the same as the US equity market.


With $1.7 billion in assets under management (as of July 2022), the firm is one of the larger players in the volatility space

Tail risk protection, which tends to focus on more distant protection against deeper drops in equity markets, is also not as simple as it might sound because the levels are a moving target and the declines might not happen fast enough for the options’ convexity to kick in. Tail risk hedging can also have hidden costs. Intuitively, protecting against an extreme tail move sounds like it should be the cheapest approach, though in practice it can entail relatively high transaction costs in terms of bid/offer spreads, which then further increase the costs of more frequent rebalancing that is needed to maintain the strategy objectives in volatile markets. “Additionally, deeply out of the money puts only pay off under rare and extreme events, for which the seller needs significant cushioning. They may look cheap in absolute terms but can be expensive in volatility terms,” says Hekster.

A dynamic approach, shifting between different sorts of hedges to optimize costs based on their relative values and payoffs, is likely to reduce costs over time. This also entails some basis risk between the hedging strategy and the targeted risk reduction so that the strategy could both outperform and underperform the target over different periods.

For True Partner, customization comes into play for the design of investor mandates. “Some investors are focused on a single type of tail risk scenario such as protecting against a 2008 or 2020 event. Others are looking to protect against a wider range of market downturns. A third group is seeking a more all-weather hedge fund return profile, but with added convexity. The types and weighting of strategies which best suit investors can differ across mandates,” says Robert Kavanagh, Head of Investment Solutions at True Partner. The firm’s suite of strategies provides options across the full range: “For example, blending tail risk and relative value can be very complementary as the different approaches offer diversification benefits. The beauty of blending relative value and tail risk in one mandate is that over time relative value can generate positive returns which go towards funding more explicit and focused tail risk protection,” adds Kavanagh.

Directional strategies can be combined with relative value approaches in varying proportions. “Individual investors can optimize their balance between the approaches, bearing in mind that relative value in itself can offer some degree of tail risk protection,” says Hekster. A benefit of relative value is that Asian markets can afford more opportunity for cross market relative value trades in the different markets, such as Japan, South Korea, Taiwan and Hong Kong. Each have their own economic and interest rate cycles as well as political and geopolitical sensitivities. There is also scope for relative value trading between continents, which could be US versus Asia or could be three legged including Europe as well. This approach could be applied for relative value trades to find the most favourably priced hedge globally.

A continuum of choices is available. For instance, “A dynamic tail risk approach aims to tactically predict volatility acceleration, and will sometimes pick up false alarms, but can produce an explosively convex payoff when shocks do materialize. In the meantime, it has a small negative cost, but this is lower than a simple put-buying strategy because the protection is conditional rather than continuous. A broader mandate could seek to provide the payoff under both sudden crash and slower drift scenarios, where the payoff would not only come from pure convexity, but also from other portfolio characteristics kicking in. This would be more costly in rising markets, but offer a wider range of protection,” says Hekster. More continuous protection is naturally more expensive and can be tailored to downside volatility scenarios. It can also profit from upside volatility when it becomes depressed.

The macroeconomic climate is walking a tightrope between recession and inflation and adverse surprises on either could unsettle equities.

Govert Heijboer, Co-CIO, True Partner Capital

Monetisation triggers

Even within a pure tail risk mandate – or the tail risk element of a blended mandate – there are choices to be made about monetization frameworks. Do investors want to cash in part or all of their protection at predetermined trigger points, calibrated to equity market moves and/or hedge profits, and then temporarily have less hedges – or even no hedges? Or do they need to maintain some degree of constant protection against more severe crashes?

Long, short and neutral volatility and risk management

Volatility strategies can have a long, short, neutral or variable volatility bias, and may have a positive, zero or negative correlation to equities. Most of the time volatility moves in the opposite direction of equity markets but there are notable exceptions: in the 2020 Covid bull market, tech stocks and implied volatility rose together partly due to heavy trading in call options by retail investors and oversized market participants, such as Softbank.

True Partner’s relative value strategies also typically maintain neutral to long volatility exposure. If the opportunity set is less compelling, the team reduces exposure but tends to avoid being outright short.

“True Partner tactically moves between neutral and long volatility stances for all current modules,” says Hekster. “And we aim to bring investors positive surprises. We’ve been doing this for long enough to know that diversification is the only free lunch, and that extreme scenarios sometimes become reality,” he adds.

Would True Partner ever consider a short-biased strategy? “There is nothing inherently wrong with short trades,” says Hekster, “we have a lot of experience actively trading both longs and shorts as part of our relative value mandate, you just need to have the right edge and risk controls.” But it is not where the firm is currently seeing the most opportunities. “Most clients now are focused on diversification, which leads to a neutral or long volatility bias. But market opportunities can change. We would be open to creating a customized short volatility mandate if that was truly the best solution for the client.”

Risk management stress tests big moves within and between markets and is agnostic on what their cause might be. Whether the scenario is Covid lockdowns, Russia’s invasion of Ukraine, tensions escalating around Taiwan or a Chinese recession, what counts is that the strategy performs when expected and that risks are effectively managed.

Strategy implementation sub-asset classes

Most ideas are expressed through options on equity indices, though occasionally single stocks can be used. True Partner also occasionally trades other asset classes, such as commodity volatility, when there are particularly compelling opportunities. The team also considers dispersion and correlation trades within equity indices when they reach extremes that present especially asymmetric opportunities.

2022 opportunity set

Different market crises and corrections follow their own paths and patterns, which means that no single hedge is a silver bullet for all scenarios. Trend following CTAs and interest rate volatility are two strategies that have worked well in the first half of 2022, but not necessarily in other periods such as late 2018. Many investors want exposure to a range of diversifying hedge fund strategies and customized tail risk solutions, including those revolving around listed and liquid equity derivatives.

After delivering strong returns in 2020, crash protection has not been so helpful in 2022 as the equity market correction has proceeded in a fairly steady and orderly fashion. The first half of 2022 has been distinguished by both equities and implied volatility dropping in tandem; the two tend to be inversely correlated most of the time.

This phenomenon has been seen across multiple equity markets in the US, Europe and Asia. “This is unusual but not unprecedented: in the early 2000s after the dotcom bubble burst, markets started with a fairly slow growth to value rotation before broadening out to a wider market selloff. Similarly, in the summer of 2008, it took some time for equity volatility to react,” recalls Hekster. If investors initially rotate from growth to value stocks, a low or sometimes inverse correlation between the two groups can help to calm down overall equity index volatility. “In 2017 the VIX was low for a long time before exploding in 2018. We can take a view on the volatility of volatility itself through instruments such as options on the VIX, which offer double leverage. The VIX itself already offers some leverage to equity market declines, and options on the VIX can further amplify this,” says True Partner co-CIO, Govert Heijboer.

The first half of 2022 has not been conducive to tail risk because there was not a convex move down, so pure equity tail risk hedges provided very little protection. Relative value has also had a limited opportunity set, in part due to low volatility of volatility. The index option markets in July 2022 have calmed down to a state that could leave value in certain dimensions of the volatility surface, such as skew, or volatility of volatility, which has dropped to pre-Covid levels. This could create more headroom to profit from any dislocations.

“In some way equities have been the odd one out so far this year,” says Hekster. “We have seen volatility rise in fixed income, currencies and commodities, but equity index volatility has remained quite subdued.” The lack of volatility moves is perhaps most tellingly illustrated by looking at strategies that sell tail risks: a simple strategy of selling out-of-the-money puts on equity indices to earn premium – the opposite of hedging – would have profited year-to-date, while the same strategy would have had substantial losses in the prior downturn in Q1 2020. This has made the first half of the year somewhat frustrating for equity volatility specialists, but from a forward-looking perspective the picture is more positive. “Equity tail risk hedges now appear cheaper than other asset classes, though you do still need to be selective as hedges generally are not cheap in absolute terms,” says Hekster.

There has been some variation between market performance this year, but less so in volatility behaviour. The market variations can help explain part of the limited volatility reaction, as there has not yet been a ‘panic’ moment at the global level, a feature often seen in downturns. Indeed, the last month the world’s major equity markets all had a negative return was back in March 2020 – that’s the longest gap since just before the “Volmaggedon” event in February 2018 when the VIX rocketed higher over a few days. Hong Kong’s markets in particular have had a close to zero correlation to US and European markets this year, while the Nikkei is only down 3% in local currency terms (though the yen depreciation would make US dollar-based returns somewhat worse). In Europe, the FTSE 100 remains up for the year.1

“There are some sound fundamental reasons for divergences,” says Hekster. “Europe has been harder hit by the Russian war and growth and inflation dynamics differ. Sectoral compositions also matter, while currencies have absorbed some of the differences in places like Japan. But as we approach a recession amid global monetary policy tightening and an energy price shock, there are echoes of 2001/02, 2008 and other historical downturns. We expect this to result in supply and demand dislocations in volatility over the coming year.” Heijboer also points out that diverging policy responses can themselves help lead to dislocations. “Divergence between policies could also create opportunities as they can lead to imbalances. The US is raising rates rapidly, Europe is raising rates haphazardly, and Japan is not raising them at all. Meanwhile China is trying to keep the economy going while maintaining its zero Covid policies and managing a real estate downturn.”

The firm sees potential for increased equity volatility over the coming months: “A possible disconnect between wider corporate credit spreads and lower implied volatility could throw up opportunities for some reconvergence between the two, which are normally interlinked. And a cathartic capitulation in equities with big shifts in asset allocation has not yet been seen,” says Hekster.

Beyond wider credit spreads, Heijboer sees a coalescence of multiple unprecedented events in 2022: “We have the highest inflation since the 1970s. Interest rates are still around zero in Europe and Japan. We have the aftermath of the Covid crisis. And energy supply problems catalysed by Russia’s invasion of Ukraine are leading to cost increases of 100% or more in some countries that are now feeding through to a broad range of production costs. All of this has happened very quickly”.

Against this backdrop, it is perhaps surprising to see equity volatility at relatively subdued levels. “If events turn out to be more severe than people expect there could be some nasty surprises for equity investors. European equity implied volatility is slightly higher than in other regions, but it is not pricing in risks including energy related inflation, or fragmentation risks such as a country deciding to abandon the euro. The next leg down in markets could be bigger. In the early 2000s, the decline started slowly and then accelerated,” recalls Heijboer. “In certain equity markets such as South Korea, implied volatility has fallen by as much as 50% and even dropped to below long-term averages. One cause of this could be structured products selling options,” he adds, “we’ve seen before that this buying can go into reverse if the environment shifts quickly.”

Geopolitical tensions could also spark off equity market volatility, potentially in Taiwan, the South China Sea or elsewhere, and the economy is also in uncharted waters: “The macroeconomic climate is walking a tightrope between recession and inflation and adverse surprises on either could unsettle equities,” says Heijboer.

Sensing opportunities ahead, True Partner has been expanding its team over the last 12 months, investing in research. “We are confident that volatility markets will provide an attractive opportunity set for investors in the coming years,” notes Hekster. “We have been able to make some great hires in areas like quantitative research, expanding our bandwidth and giving us opportunities to grow in adjacent markets.” As we approach an uncertain market environment, this could also be a good time for savvy investors to revisit the volatility space.