Asset Owners Cautiously Pursue Volatility Strategies

Skilled hedge fund managers can demonstrate they can go both long and short volatility. Volatility specialists thrive on uncertainty. They are excited when things blow up. These hedge funds are waiting for another “Lehman” event aka black swan. Institutional investors have been analyzing relative value hedge funds and funds that have a long volatility strategy for quite some time. A number of prominent public investors and endowments are seeking to carve out volatility management strategies as a separate asset class. Skeptics cite volatility is not yet an asset class. This class contends that volatility is purely a statistical measure of dispersal of returns, not an asset class, but a derivative of other asset classes.

It is nearly impossible to contain downside risk while not surrendering upside potential.

Sovereign funds that have low levels of portfolio leverage, high liquidity and long investment horizons may not want to buy equity tail-risk insurance. Allocating capital to volatility managers or embracing dedicated tail-risk hedging strategies can be costly and challenging to execute. As market risk increases, the costs of tail-hedging increases. These “insurance” costs are a drag on portfolio performance. Some sovereign funds like the China Investment Corporation (CIC) have rejected tail-risk hedging strategies after conducting studies, but would consider allocating capital in separate accounts to volatility managers. On average, tail-risk strategies performed poorly since 2009, while many public investors regained traction after the major market downturn of 2007.

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