Tags: Hedge | Funds | Market | Tumult

Tough Times for Hedge Funds That Bet on Market Tumult

Wednesday, 01 May 2013 07:03 AM

 

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Nelson Saiers, a trader and math whiz, runs the type of hedge fund that tends to perform best when markets are going haywire.

The $600 million Saiers Capital fund and other so-called volatility funds use complex trading strategies to take advantage of pricing discrepancies caused by gyrations in global financial markets.

These funds flourished in the years after the financial crisis, when volatility was running hot, but this year is a different story.

Financial markets have been largely moving upwards with few wild swings along the way. The Standard & Poor's 500 index is up about 11 percent and the closely watched CBOE Volatility Index hit a six-year low in March.

Saiers Capital's fund is down about 1.24 percent through April 26, according to an investor. Overall, volatility funds gained 1.16 percent in the first quarter, according to hedge fund tracking firm eVestment, underperforming the broader hedge fund industry's 3.7 percent gain.

Saiers, who manages one of the better-known volatility funds, declined to confirm specific return figures but said some of his fund's underperformance this year is the result of a deliberate strategy to put on trades that would profit in the event of a U.S. stock market crash.

"If you buy crash protection you most likely lose a small amount of money, but if there is a crash you make a windfall," said Saiers, who earned his doctorate in mathematics when he was 23 years old and joined the Alphabet Capital hedge fund in 2010. Alphabet changed its name in December to Saiers Capital to recognize his contribution to the firm's performance.

Many volatility traders are math nerds like Saiers, who cut their teeth on Wall Street trading derivatives or working on quantitative trading desks. Others come from the options pits or were specialists in statistical arbitrage.

But one thing all volatility traders abhor is calm markets.

"This is an environment to hit singles and doubles as opposed to home runs," said Joshua Thimons, a portfolio manager with the Pimco Multi-Asset Volatility Offshore Fund, which the Newport Beach, California-based investment firm launched in 2011.

The $1 billion volatility hedge fund run by bond giant Pacific Investment Management Co fell 1.4 percent during the first quarter, according to data from HSBC's Private Bank. Thimons declined to comment on the figure.

Last year, volatility managers were able to boost returns with successful bets on price dislocations triggered by the European crisis in May and June. The Pimco volatility fund gained 13.4 percent, while Saiers Capital was up 10 percent. The average hedge fund was up 6 percent last year.

TAIL RISK

This year's flattened returns are one byproduct of efforts by the Federal Reserve and other central banks to keep interest rates low and create a more tranquil trading environment.

The Volatility Index fell 30 percent during the first quarter from 18.02 to 12.70. The VIX is often referred to as Wall Street's "fear index" because it tracks the price of puts on SP500 index options. In periods of relative tranquility, demand for puts falls as they are often used as insurance against a market slide. A put option gives the holder the option, but not the obligation, to sell at a set price by a certain date.

"The low-volatility environment could potentially persist for the next few years," said Vishnu Kurella, portfolio manager at BlueMountain Capital, which has a $600 million fund that specializes in equity derivatives and volatility trading. "With extremely accommodative monetary policy and supportive fiscal policy, governments globally have all but committed to supporting the markets."

BlueMountain's portfolio is one of the few volatility funds doing well in 2013, up 3.74 percent through April 12, according to data from HSBC's Private Bank. Kurella declined to give specifics of the fund's performance.

For the most part, volatility funds remain a small corner of the hedge fund world, representing roughly $17 billion of the industry's $2 trillion in assets. But last year PIMCO's volatility fund scored a coup when the Pennsylvania Public School Employees' Retirement System allocated $220 million to its fund. The pension fund did not return a request for comment on whether it was satisfied with its investment in the fund.

One reason volatility funds have attracted investors is that they are not merely positioned as "tail risk" funds that make money when financial markets implode. The funds, which buy and sell options linked to an underlying asset, aim to take advantage of mispricings in stocks, currencies, commodities or bonds in both rising and falling markets.

A big component of an option's price is its implied volatility, or the likelihood for a sudden swing in the price of the option or the underlying asset. Low implied volatility typically translates to a low price.

Many volatility funds tend to bleed when markets are stress free. In March, for example, 7 out of 10 funds that comprise the Newedge Volatility Trading Index posted negative returns, according to the broker. That index fell 2.6 percent in the first quarter.

TEMPORARY SETBACK?

The Saiers fund pared some losses as April progressed, according to the investor.

Saiers said underperformance in his fund is a temporary setback and he stands by the decision to purchase crash protection even though the trade has eaten into returns. Though he doesn't think a stock market crash is imminent, he said macro uncertainty persists.

Even if a U.S. stock market crash is not in the offing any time soon, volatility investors say there is money to be made with bets tied to Japan's recent embrace of Fed-style easy money policies.

Pimco's Thimons said the Bank of Japan's "extraordinary balance sheet expansion" has triggered big swings in the country's currency and interest rate markets and his team has "dedicated a significant amount" of time to looking at trades that capitalize on those mispricings.

For BlueMountain's Kurella, government intervention in the financial markets should not stop volatility investors from making money.

"While the environment feels like low-vol in the US, Japanese equities are up 60 percent in the past six months," Kurella emailed. "And that's anything but low volatility."

© 2014 Thomson/Reuters. All rights reserved.

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