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Unexpected events occur more
frequently and with larger impact than the markets often anticipate. Examples
are international events (September 11, the outcome of the US election in 2000,
the 1990 invasion of Kuwait), financial crises (Sterling dropping out of ERM,
Russian default, the bursting of the NASDAQ bubble in 2000), dramatic moves of
certain assets or markets (oil falling to $10 a barrel, then rising to $35),
earnings surprises in market sectors, etc. Exploiting the frequency and the
magnitude of such events is an excellent conservative, long-term strategy for
wealth accumulation.
To capture the effect of
events in the markets, the fund selectively buys volatility. Volatility
is a measure of how much an asset moves, not of whether the asset moves up or
down. To buy volatility, the fund buys options and eliminates their exposure to
the prices of the underlying assets. For example, to buy volatility on a stock,
the fund buys a put on the stock and an “appropriate” number of shares, so that,
as the price of the stock changes, the combination of the put and the shares
neither makes nor loses money: the gain (loss) in the put offsets the loss
(gain) in the stock.
Volatility moves higher
when an asset makes a substantial move, either up or down. As a result, the
investment approach aims at anticipating market moves, not at guessing the
direction of the market. In fact, the approach is strictly “market-neutral”: the
fund never takes a view as to whether an asset will move up or down. Returns do
not come because an asset moves higher or lower; they come because the market
reassesses how much the asset moves (and because the fund constantly adjusts
positions, to eliminate exposure to asset prices).
The investment approach is predicated on the following principles:
Market participants occasionally do not account fully for the amount of
uncertainty in the markets
Large market moves, either to the up-side or to the down-side, cause
volatility to move higher
Volatility is contagious: volatility increases in one market and tend to have
a similar effect in other markets
Volatility as an Asset
There are compelling reasons for investing in volatility:
- Volatility is often overlooked as an asset and, as a result, offers some excellent
risk/reward opportunities.
Volatility is overlooked, especially in the equity markets, because
- The concept often carries a negative association and instills fear in many
investors, and
- relatively few investors possess the quantitative skills,
or experience, to feel comfortable with it
- Investing in volatility offers the potential for good returns in up or down markets.
This is the case because in sharp market moves, either up or down, volatility moves only up
- Volatility is an excellent diversification tool
For most assets (stocks, bonds, currencies, etc.), the asset and the
volatility of that asset are negatively correlated (they move out of sync).
As a result, any investor with exposure to equities can benefit greatly
from investing in volatility, because combining equities with equity
volatility results in lower overall risk and usually enhanced return.
Disclaimer Past performance is no indication of future performance.
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