Hedge funds have enjoyed a strong start to the year, having produced, on average, positive returns in the first two months [see Market round-up, this issue]. Some managers attribute the results to a long-awaited return in market volatility but views are mixed on whether or not it really has come back.
Peter Borish, CEO of Twinfields Capital Management, a global macro, rapid-trading shop focusing on treasuries and currencies, is positive that market volatility has returned and will be sustained. “Over the last couple of years,” he says, “seemingly uncorrelated markets became correlated, such as the dollar and gold. That has corrected now and has resulted in an increase in volatility. The pick-up in Japan and the bottoming out of the fixed-income market have had a similar effect. There is a lot of uncertainty at the moment, creating volatile markets, and the knock-on effects of past monetary policy are beginning to filter through. Higher energy prices, higher mortgage rates, a slowdown in economic activity and the continuing story in Iraq are creating uncertainty and a depletion of cheap money.”
James Skeggs, head of statistical reporting at Fimat’s Alternative Investment Solutions in London, also believes that market volatility could begin to pick up. “Financing is becoming more expensive, thus increasing the cost of gearing and therefore the volatility at the company balance sheet level. This will result in increased equity market volatility at some point. Higher interest rate costs due to change in monetary policy bias in Japan and Europe will affect the universe of carry trades and also create market volatility.”
An increase in market volatility is evidenced by returns of Fimat’s volatility arbitrage median, FVAM, a performance measure for funds that trade volatility as an asset class. FVAM returned 1.09% in 2005 and it is estimated that it was up 78 basis points in the first two months of 2006. In contrast to 2003, when the FVAM returned minus 5.55% and in 2004 minus 0.48%, the measure has indicated negative returns in only two months (October and December 2005) in the past 11 months.
“Markets with increased risk premia provide more of an opportunity for hedge funds in certain strategies to make returns,” says Skeggs. “For example, volatility arbitrage, global macro, managed futures (CTA), statistical arbitrage, and other strategies with a long volatility profile.”
Borish says that those hedge fund strategies that count on short-term trading will benefit as volatility increases. “If volatility is increasing then there are more opportunities. Transaction costs have come down, and it is possible to trade in large sizes. The short-term trader will benefit from the new environment. The buy-and-hold longer-term hedge funds, however, will not be able to take advantage.”
Dissenting voices
But not everyone in the market is as confident that volatility is making a comeback. One hedge fund industry participant says: “I think that low market volatility is something we’re going to have to get used to. Markets are getting more efficient, investors are becoming more rational and information is more widely distributed. Although still not at the ideal level required by the efficient market hypothesis, I think the trend is in that direction.”
Jerry Hanweck, founder and principal partner of investment consulting firm Hanweck Associates, is also dubious about the return of volatility. “What you need to find is the trigger that would cause a lack of investor confidence,” he says. “Last time volatility and other measures of risk (for example, credit spreads) were this low was the period from 1995 to mid-1997. The catalyst that finally drove risk premia higher was the Asian currency crisis of 1997. Otherwise, many of the same factors are at work to keep volatility low: inflation is under control, the Fed is near the end of a tightening cycle, interest rates are low, and economic growth and corporate earnings are steady.”
At present, such a trigger does not seem to be on the near-term agenda. “So far, the markets seem quite happy with the new Fed chairman,” says one trader. “Although he does introduce uncertainty, I don’t think that will be a catalyst for major volatility. Ditto for the housing bubble (which everyone has already considered), and credit derivatives clearing (which had the potential of a Y2K, but like Y2K will proceed without a hitch). People are starting to worry about ‘the hyper helpers’, or waste from excessive financial intermediation. You know things are calm when something that abstract is getting press.”
Time to trade volatility
Market volatillity is slowly increasing |
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| Source: Fimat Alternative Investment Solutions |