Volatility Arbitrage

Benefits of volatility arbitrage allocation in a fund of funds

ARIÉ ASSAYAG, SGAM AI

The SGAM AI Hedge Fund team has conducted extensive research on volatility arbitrage strategies for liquid option markets since 2002. It has developed a Volatility Platformwhich encompasses a wide variety of funds that exhibit consistent, positive returns which are de-correlated to traditional asset classes. This Volatility Platform currently manages more than US$800 million.

The performance of our volatility arbitrage funds has been strong during the difficult market conditions of the past year, which has proven the strength of the de-correlation to traditional asset classes. More importantly, we have discovered during this period of market dislocation that portfolios which combine our volatility arbitrage strategies with our funds of funds (FOF) and/or equity programmes show significant improvement to overall performance.

We performed an extensive analysis which examined the benefit of including volatility arbitrage strategies in a diversified FOF portfolio. Instead of focusing on any specific fund in the analysis, we took into consideration two indices that best summarise the overall performance of volatility arbitrage strategies: HFRX Volatility Index (HFRXVI) and Newedge Volatility Trading Index (VTI). HFRXVI, provided by Hedge Fund Research, is comprised of an undisclosed number of funds which trade volatility as an asset class. Funds included in the index utilise arbitrage, directional, market neutral or a mix of types of volatility trading strategies1. VTI is an equally weighted portfolio constructed of 11 funds that employ volatility trading and arbitrage style2. The historical return series of VTI ranges go back to January 2003, while HFRXVI return series starts in January 2004. We used the VTI index in the analysis to examine the behaviour of volatility arbitrage strategies over a longer time frame.

The recent turmoil in financial markets has highlighted the importance of volatility arbitrage strategies as a diversification tool for a FOF portfolio. Comparing performance of VTI and main hedge fund strategies over the highly volatile environment from July 2007 to March 2008, we observe that volatility arbitrage proved to be more resilient and outperformed the main hedge fund strategies through the period.

Understanding the performance of volatility arbitrage strategy

In general, both level and volatility of VIX have an impact on global hedge fund performance. Indeed, a rise in the level of VIX or VIX volatility has an increasingly negative impact on the average performance of hedge fund strategies. This is not surprising as VIX volatility is an increasing function of the level of VIX. As VIX level increases the more important VIX variability becomes. Thus, with increasing dispersion of the volatility, it becomes harder to forecast the level of VIX. In periods of high uncertainty regarding future implied volatility, signalled by an increase in the volatility of VIX, volatility arbitrage strategies perform well due to the difficulty of foreseeing the future level of VIX and the existence of more opportunities for volatility trading strategies. Looking at Figure 1, we observe that volatility arbitrage funds benefit from elevated volatility of VIX. It shows that improved performance in VTI coincided with higher levels in VIX on a statistically significant basis.

Fund of funds’ allocation to volatility arbitrage strategy

Given the de-correlation of volatility arbitrage strategies with traditional asset classes, as observed in the previous section, it is important to determine if FOF portfolios can benefit from allocations to volatility arbitrage. We have run our proprietary Risk Aversion Optimisation (RAO) method using 4 instead of the usual 3 strategies, with no constraints. The strategies considered were: equity hedge, relative value, global macro (the usual 3) and volatility arbitrage. HFRX indices were used to represent the 3 main hedge fund strategies. The period of the analysis was from April 2003 (inception date of the HFRX indices) to May 2008. The introduction of volatility arbitrage radically changes the architecture of traditional portfolio construction. Our model indicates that volatility arbitrage outperforms relative value across all market configurations.

Interestingly, the model recommended a significant allocation to volatility arbitrage which confirmed the fact that volatility arbitrage also outperformed the other strategies during periods of high market risk and uncertainty. This is an exciting result for the hedge fund industry because it proves that allocation to volatility arbitrage can significantly improve FOF performance during periods of high volatility without degrading performance in standard market conditions.

At the current value of the Risk Aversion Coefficient the optimised allocation among the four strategies was: 25% in equity hedge, 21% in relative value, 16% in global macro and 38% in volatility arbitrage. Nonetheless, during the entire period the model has shown that a significant allocation to volatility arbitrage is an important optimisation tool. Of course, we do not recommend a 40% allocation in a fund of funds. But gradually rising, it can represent 15% to 20% of the allocation in the years to come.

Thanks to the development of our Volatility Platform, we are able to construct products with return profiles negatively correlated to equity markets. These strategies blend well with other strategies in SGAM AI’s Hedge Fund platform, especially with FOFs and equity programs. This represents an important milestone with significant implications for the hedge fund industry. Increased allocation to volatility arbitrage can improve performance for FOFs across all market configurations. We believe this will lead to greater focus on volatility arbitrage and overlay programmes as well as more attention and allocation to alpha volatility funds.

1. Hedge Fund Research. “HFRX Volatility Index factsheet.” March 2008, HFR official website. April 2008 .
2. Newedge Group. “Newedge Trading Volatility Index (VTI) factsheet.” April 2008. .

Arié Assayag is the Global Head of Hedge Fund Activity for SGAM AI. Before joining Société Générale Asset Management, in Paris, in 1999, he began his professional career as a Forex Derivatives market maker at Société Générale. In 1987, he set up and headed the Tokyo Forex Options and SG Derivatives business in Asia, then became, in 1989, Head of all Société Générale FX Option business in Asia. In 1990, he set up and headed the US Derivatives on Regulated Markets for Société Générale. He then joined Citibank as Head of EMS FX Derivative. In 1994, he joined, as a founding partner, Commerz Financial Products where he was Head of FX Derivatives. Mr. Assayag graduated from École Centrale de Paris.