Search for alpha in a volatile world

Alpha generation can be an elusive goal, particularly when trading volatility. Three different approaches to trading volatility were discussed by a panel looking at the role of systematic and carry strategies in finding profit in a high-volatility world

Laila Mukhey, Societe Generale

Volatility spikes are becoming more frequent but are also short-lived. Over the last four or five years, investors have become used to them. With the prevalence of risk premia and volatility-selling strategies that dominate the front-end of the vol curve, many see these spikes as an opportunity to buy underlying assets, said Will Bartlett, chief executive officer at US-based Parallax Volatility Advisers in a panel at the Societe Generale/Risk.net derivatives conference.

Looking at implied volatility on most products in the 30-day or less time frame, investors consistently trade under realised. Putting this gamma onto the books of firms such as Parallax that are natural hedgers has tended to make the suppression of volatility a “somewhat self-fulling prophesy where we buy straddles; effectively, the sellers don’t hedge them. The market trades down and we’re buyers of whatever we bought the straddle on. The market trades up, and we’re sellers,” explains Bartlett. 

Parallax started as a floor-based market-making group on US regional exchanges and has evolved into a global relative-value/volatility-trading firm with a heavy emphasis in the US equity and index markets. The firm manages just over $3 billion across a range of funds.

However, the volatility Bartlett describes is actually suppressing volatility and is driven by demand for yield.

Taking a slightly different view of volatility is the chief investment officer at Man Group, Sandy Rattray. The London-based hedge fund group is the largest in Europe running both quantitative and discretionary strategies in all liquid assets globally, as well as active in the macro volatility rather than single-name volatility area.

Will Bartlett, Parallax Volatility Advisers

Rattray sees three themes affecting volatility at the moment. First is politics. Central banks are trying to suppress volatility while politicians appear to be playing a “very different game. It doesn’t matter where you look in the world. Politicians are creating the circumstances for volatility,” he says.

Second is the growth of quantitative strategies, in all their forms, within and outside volatility trading. “One technique that has really worked for the last 20 to 30 years in systematic trading is scaling your positions by some measure of volatility: short-term, medium-term or higher-realised volatility, but usually not long vol. It doesn’t really matter what it is. Generally, it is not very long-term and quite short,” he noted.

However, as markets go down, volatility tends to go up. This feedback mechanism has caused many to believe quantitative strategies are causing market instability. “I don’t agree with this. I think volatility scaling, if everyone is doing it, creates an instability and there are certainly a lot more people doing that,” said Rattray.

The third factor is market microstructure. “From my perspective you have a number of things coming together, with banks committing dramatically less capital to markets,” Rattray continued. “At the same time, you have an enormous rise of high-frequency traders. This is actually a better way of market-making than people with telephones on floors could do. However, these people don’t have anything like the market-making obligation that existed in the past. There is a clear instability that has come out of this,” he concluded.

Arnaud Sarfati, co-founder of La Française Investment Solutions (LFIS) , agreed that investors are looking for solutions due to low interest rates and the lack of perceived opportunities in the liquid markets. Liquidity is a continuing problem. “The environment is difficult to navigate whether you are short or long volatility,” he says. “It is a shifting environment.”

Sandy Rattray, Man Group

LFIS, which runs around €13 billion, combines investment management experience, derivatives expertise and specialist quantitative capabilities to offer clients differentiated solutions using a multi-asset approach to extract value and deliver long-term performance.

Bartlett said that providing liquidity has become a large part of his firm’s strategy. “Although it’s always been a consistent factor in our strategy, in the last four or five years we’ve been buying liquidity in about 75% of our trades,” he says. 

Rattray has a different experience: he said that over the last 20 years when equity went down, bonds went up and “saved” investors. “You might reasonably think this is a normal state of affairs and it has been for 20 years,” he said. “But if you look at the previous 250 years, there has been no period of time where the relationship is consistently that when equities go down, bonds went up.”

Everyone now seems to accept that bonds diversify against equities: a notion particularly prevalent in the US pension fund industry and most insurance companies. One way to challenge this idea, said Rattray, is to ask what happens if there is a crisis in the bond market. “Are you going to be saved by the equity market? I think almost no one would think that,” he concluded.

Bartlett agreed and also saw big risks in this approach. “Thinking that what happened over the last 20 years will happen over the next is a bad way to risk manage a book, a portfolio or almost any set of risk that has equity and bond risk together,” he said.

Arnaud Sarfati, LFIS

Meanwhile, the actual providers of liquidity have changed, causing unstable correlations, with investors craving yield through a multitude of strategies. This has helped crowd some strategies and is also causing some volatility. 

“The VIX blow-up in February 2018 was just a taste of the potential for the unwind of short volatility strategies,” says Bartlett. “We saw a $2 billion levered ETN that blew up because the S&P [Standard & Poor’s] sold off 5% in an orderly fashions and the VIX went to 48.” The idea that in any selloff you sell the spike in volatility is a false one, he said. “Just because it has worked well does not mean it will in the future. The effect is that the short-vol trade on the short end of the curve is crowded.”

Rattray had a more radical view. “When we first looked at the VIX in 2003, we didn’t much like it,” he said. While most think the way to make money out of the VIX is through exchange-traded funds (ETFs), Rattray has reservations. “The short ETFs may look attractive in the near term, but I think they are all bad because they are extremely unsophisticated strategies that have been packaged. A short VIX ETF cannot adjust and has to keep on buying to adjust its short position. This is not sustainable,” said Rattray. 

“I’ve seen a kind of religious conversion where people believe backtests. You have these extremely simple strategies with people believing them. That’s particularly taken place in factor investing, a place where it’s modestly dangerous. The moment you get to non-linear products, it’s lethal,” he declared.

Sarfati sees market concentration rather than overcrowding as a problem. He also defends risk premia – around since the 1970s and a staple of LFIS’s strategies. “The big difference today is that risk premia have become very systematic, and so the market is much more concentrated. This leads to volatility of vol.”

To counteract this effect, LFIS emphasises diversification and making sure it is possible to scale positions within the portfolio. “This makes a difference,” Sarfati said.

For Rattray, the most crowded space is active equity management. “There is a shrinkage that’s taking place. Our job description is to take risk. People say they want you to take risks but actually they don’t want you to take very much at all. That’s a very odd sort of thing: you either want someone to take risk or you don’t and if you don’t, you’re better being in an index rather than with an active manager.”

Bartlett thinks short volatility is crowded and “will end poorly” because people do not appreciate the risks of the positions, coupled with the belief that bonds and equities are uncorrelated. 

The availably of near-term volatility is another factor, particularly in US equities, where the demand is for skew, noted Bartlett. “That imbalance is basically where you can buy short-dated S&P gamma, say at eight to 12 implied vol, and sell six-month downside puts at 25 to 30 because of these large structural flows, the supply of vol from sellers and the demand of downside protection from hedging strategies. They are basically buying the most expensive option and buying the market while selling the cheapest option.”

As usual, the Man Group, which runs large portfolios, has a different view. “We’re basically a long volatility business,” said Rattray. “Generally, we are short options, although extremely dynamic in how we manage risk. It is a relatively modest allocation for us and so from that perspective, if it goes badly, we think we’ll be okay in the other 95% of our risk.”

Man finds opportunity in volatility since positions need to be quite large by going across all of the markets. “You can get all sorts of interesting opportunities across the foreign exchange markets, for examples”, said Rattray. “We expect quite low Sharpe ratios in each of our systematic strategies and have relatively genuine diversification by building across as many different markets as possible. This has been our edge. We don’t do one-off large trades. We make money by being consistently in all these markets and making sure we’re present all the time.”

Sarfati prefers to run a dispersion book within his funds and diversify this way. “We trade geometric dispersion. We sell volatility on the index but can decide to enter a dispersion strategy where we buy a basket of volatility swaps on a single name but sell vol on the basket. We believe there is more opportunity on geometric dispersions.”

For Bartlett, the key to surviving is to take a relative-value approach, particularly in volatility. “We mistakenly thought that volatility was really cheap for five or six years. It turns out it’s just been really low.” He also recognised it is not possible to see the future. However, the market will always continue to present mis-pricings and identifying these is important.

He concluded: “Dispersion is a great strategy sometimes. But systematic dispersion can be disastrous. We made all of our money in 2010, 2011 and 2012 in dispersion coming out of the financial crisis. But dispersion hasn’t worked that well this year. Implied correlations have increased, and we see realised correlations also increasing. It hasn’t been profitable for us. To do it consistently, especially when implied volatility and implied correlations are low, is like picking up pennies from in front of a steamroller: it could be disastrous.”

 

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