The demise of the short volatility Exchange Traded Note (ETN) with ticker XIV, has led some media observers to suggest that the short volatility trade is dead. I would argue that many short-biased strategies continue to thrive, but trading volatility requires a more sophisticated approach than either long-only or short-only.  

By Hamlin Lovell

The death of XIV was bound to happen sooner or later. A short-only strategy carries theoretically unlimited risk. If a strategy is 100% short of anything which rises by at least 100%, the value drops to zero. The XIV prospectus warned that the long term expected value was indeed zero! On February 6th 2018, XIV lost nearly all of its value, and Credit Suisse decided to close it (a handful of other short volatility ETFs/ETNs still exist, and most are down around 90% in the first two months of 2018).

Long-only volatility ETFs are up 40-50% in the first two months of 2018, but this is starting from a very low base. Long term, they have often lost over 99% of their value, because im-plied volatility trades at a premium to realised volatility most of the time. The negative compounding effect results in a value that asymptotically approaches zero. This also means that shorting volatility is one of the most persistent risk premiums.

Volatility risk premiums
Short-biased volatility strategies will typically sell volatility on a limited risk basis. This might involve “selling the belly and buying the wings”, in the jargon: this might be imple-mented by selling options 10% either side of the current market price, and buying them 20% or 30% either side. It could entail spread trades, that are short of volatility below one strike price, but long of it above a higher strike price. It is possible to buy call options on the VIX future, to hedge a short position.

Or it could simply involve smaller position sizes with a strict money management rule that banks profits at regular intervals to stop the position from growing too large; in contrast the ETFs reset their exposure daily and stay more or less fully invested. Selling volatility is not a strategy, like finding the next Netflix or Amazon, where investors should run their winners for years. In common with owning catastrophe bonds that saw big losses in 2017, the ques-tion is not if, but when, large losses will occur.

Short volatility strategies aim to capture a volatility risk premium. They can be invested in on a standalone basis, and are also important building blocks for the growing number of “style premia” and “alternative risk premia” strategies that aim to offer “alternative beta” or “exotic beta”. If investors are exposed to five or ten or fifteen different, and lowly corre-lated, sources of risk premiums, then a large loss on one of them will have limited impact on the overall portfolio.

Risk premia funds are often in a UCITS structure and tend to have a fee structure that is higher than ETFs, but lower than most hedge funds.

Volatility hedge funds
Both short-biased, and long-biased, volatility hedge funds have made positive returns over the long run.
The CBOE Eurekahedge Short Volatility Hedge Fund Index, has, unsurprisingly, lost money in 2018. It is down 6.02% – but that is less than the 9.07% made in 2017. (The UCITS funds that I track in the space often run at lower volatility targets, and have generally lost less). The index has made average annualised returns of 8.17% between January 2005 and Febru-ary 2018.

The CBOE Eurekahedge Long Volatility Hedge Fund Index, has made average annualised returns of 4.7% between January 2005 and February 2018 (much of which came from 45.81% in 2008).

Skin in the game
Why might the performance of volatility ETFs/ETNs and volatility hedge funds be so differ-ent? One reason could be the incentive structure. The ETFs/ETNs generate management fees, and it is not clear whether those who manage them have any personal investment or “skin in the game”. Assuming they do not, the blow ups of these ETFs may not have hurt them. Credit Suisse put out a statement saying that the bank had no net exposure to XIV. (Under risk retention rules, banks are required to retain exposure to securitised credit vehi-cles such as pools of mortgages, but apparently do not need to “eat their own cooking” when it comes to ETFs and ETNs).

In contrast, hedge funds aim to align interests between managers and investors in two main ways. They charge performance fees, and their managers should have a significant proportion of their liquid wealth personally invested in their funds.

Relative value strategies
Is there a happy medium between long-only and short-only? There are many other approaches that can have a market neutral position in volatility, and instead trade relative value between and within volatility markets. This might involve calendar spreads, or skew trading. It can also trade options embedded in convertible bonds. Trades may be loosely described as “arbitrage”, but rarely meet the strict definition of risk free trades. Some volatility traders have also spread their wings into other asset classes, such as bonds, currencies and commodities.

Selected volatility hedge funds
The best discretionary volatility hedge funds have profited during both high and low volatility climates, and in both rising and falling volatility regimes.

For volatility hedge funds with some tail risk or long volatility exposure, February 2018 was a great gift.  At least one hedge fund (reportedly Capstone) was short of the XIV ETF. Capstone has a long track record of delivering positive returns in a wide range of volatility climates, and is thought to manage capital for major pension funds.

Another consistent performer is Hong Kong based True Partner, which trades volatility within and between in multiple Asian and US markets. The manager’s breadth of coverage allows it to identify many cases of anomalously priced volatility in equity markets. True Partner had a banner month in February 2018, making 21%.

True Partner was the last fund seeded by hedge fund seeder, IMQubator, which had capital from Europe’s largest pension fund, APG. I worked at IMQubator between 2011 and 2013.