Volatility Hedge Funds: The Good, the Bad, and the Ugly

Exploring strategies in the volatility space

September 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Volatility hedge funds provided attractive diversification benefits for equity portfolios
  • However, long were preferable over short volatility strategies
  • Some scepticism is required for the hedge fund index performance

INTRODUCTION

In finance 101, there is usually little doubt on what constitutes the major asset classes in the investment industry, i.e. there are the traditional ones like equities or fixed income as well as alternatives like real estate or private equity. The instruments of each of these asset classes have unique characteristics. Stocks have unlimited while bonds have limited upside, but both are typically regulated securities. In contrast, private equity and real estate are mostly unregulated and private investments. Seems like clearly differentiated asset types.

However, we can change the perspective and make the case that all of these are the same bet on the economy continuing to hum along. None will do particularly well when the economy is heading into a recession. Equity, whether held publicly or privately, and bonds of corporates, as well as buildings, will decline in value. These assets provide the same exposure to the economic factor and could therefore be considered as diverse components of essentially the same asset class.

How about hedge funds? Some have labeled these as a distinct asset class, others as structures of getting exposure to existing asset classes. The New York Times called them compensation structures for the ones who operate them.

It gets even more challenging with volatility, which is traded and represents a derivative of equities. There is unlikely a definite answer.

However, volatility is interesting as it is broadly negatively correlated to economic growth. When the economy is growing, then economic and financial volatility tends to decline. And vice verse, when the economy is declining, volatility tends to increase (read Thou Shall Not Short the VIX).

Given this, volatility strategies might be attractive for diversification, even if it might not be an asset class on its own. In this short research note, we explore