Global Asset Management

True Partner article: Volatility Arbitrage and Tail Risk

Page 1: Helping investors adapt to the new market paradigm

Originally published by Hamlin Lovell in The Hedge Fund Journal of 09-2022

To brave the upcoming winter storm, investors have more sophisticated financial tools at their disposal.
Winter Landscape, Jacob Isaacksz van Ruisdael, c. 1665. Dutch Master Jacob van Ruisdael depicted this Winter Landscape towards the end of the Dutch Golden Age.

Investors are rethinking their portfolio diversification assumptions after equities have started 2022 with the worst first half of a year in decades, while government bonds and corporate credit have also posted double digit losses. Unprofitable and long duration growth assets have seen the steepest drops, but higher interest rates are challenging, repricing and recalibrating all assets – including private equity and venture capital valuations – at a time when inflation raises the bar for real returns.

Many institutional investors are re-examining how volatility strategies could complement portfolios, adapt to the new paradigm and help meet a diverse spectrum of investment objectives and constraints. Customisation is in particular focus as different investors have various tolerances for portfolio losses under different sorts of correction, crisis, crash and tail risk scenarios and also have different budgets for any ongoing portfolio insurance costs in normal climates. This influences at what levels of market setbacks they would seek to partly or wholly monetize hedges. Customisation can allow investors to define parameters around these variables and devise a good fit for their portfolios, strategies and platforms. Regulatory and fiduciary constraints for pension funds, insurance companies, endowments and foundations can also be factored into the architecture.

“Customisation lets investors tailor hedges to their worst scenarios for various asset classes. For instance, a recessionary slowdown would benefit bonds and hurt commodities whereas an inflation spike would do the opposite,” says Tobias Hekster, co-CIO at True Partner Capital, based in Chicago.

   We’ve been doing this for long enough to know that diversification is the only free lunch, and that extreme scenarios sometimes become reality. 

Tobias Hekster, Co-CIO, True Partner Capital

Hekster and the other founders of the firm have been active in equity options for the last two decades, in Europe, the US and Asia, initially for proprietary trading houses and market makers, before they set up True Partner. Its flagship relative value strategy was launched in 2011, a long volatility biased strategy was rolled out in 2016, and now a suite of customized offerings is a natural and logical evolution of the firm’s mission to deliver alpha for investors. With $1.7 billion in assets under management as of July 2022, the firm is one of the largest and longest established players in the volatility space.

Veteran volatility managers

Multiple solutions are on offer. Experienced equity volatility managers who have navigated a variety of bullish, bearish and flat market and volatility regimes are increasingly sought after. Investors with global portfolios want to access equity volatility markets in the US, Europe and Asia around the clock to take advantage of dislocations, anomalies and inefficiencies within and between markets, inside and outside normal market trading hours. Seasoned portfolio managers who have previously worked as market makers and proprietary traders understand the incentives and motivations of those on the other side of the trade.

Options should not be seen as a zero-sum game, because they are only one part of portfolios. Different market participants are using options to achieve different objectives in their portfolios: some are enhancing income while sacrificing some upside and others are truncating downside, without necessarily seeking an absolute return from the option component in isolation. In contrast, those who are purely or primarily trading options view the whole volatility surface through their own analytical prisms.

Veteran volatility managers also have the software to model option portfolios’ multi-dimensional and dynamic risk profiles, and the wherewithal to employ and manipulate gargantuan repositories of historical data.

Instruments and implementation

Customisation at the level of individual investment instruments can entail exotic, esoteric over the counter (“OTC”) instruments, which might be difficult and subjective to price and sometimes harder to trade, but these qualities are not inescapable features of bespoke volatility strategies. It is possible to use only liquid, exchange listed, standardized, and easy to price volatility instruments to construct customized mandates that avoid operational complexity, counterparty risk and potential illiquidity.

With $1.7 billion in assets under management (as of July 2022), the firm is one of the larger players in the volatility space.

The liquid volatility space is highly unusual in exhibiting counter-cyclical liquidity: volumes traded tend to increase in a crisis precisely when liquidity can be evaporating or intermittent in some other markets. Whereas OTC option market liquidity can become impaired, liquid and listed options allow for rapid monetization, not least because market makers are obliged to continue providing quotes in certain key parts of the market. In addition, some investors, or automated hedging programs, tend to buy more insurance after panics, whereas a well-designed volatility program could well be moving in the opposite direction and cashing in on well-bid protection at these times.

Furthermore, customized option mandates can be structured in a capital efficient manner as the inherent leverage of options contracts also allows for large notional exposures with limited cash outlays, often via managed account structures, potentially freeing up capital for other parts of portfolios.

Balancing tail risks and relative value

A simple approach of buying put option protection is generally expensive because implied volatility is usually above realized volatility – and this was true for US equities even in the first half of 2022, surprising many investors. A “naïve” or simple put protection strategy might well have lost money over this period. For instance, the PPUT Index – which combines long equities with 5% out of the money put options – offered no real protection in the first half of 2022. As of mid-June 2022, it had lost about 25%, approximately the same as the US equity market.

Tail risk protection, which tends to focus on more distant protection against deeper drops in equity markets, is also not as simple as it might sound because the levels are a moving target and the declines might not happen fast enough for the options’ convexity to kick in. Tail risk hedging can also have hidden costs. Intuitively, protecting against an extreme tail move sounds like it should be the cheapest approach, though in practice it can entail relatively high transaction costs in terms of bid/offer spreads, which then further increase the costs of more frequent rebalancing that is needed to maintain the strategy objectives in volatile markets. “Additionally, deeply out of the money puts only pay off under rare and extreme events, for which the seller needs significant cushioning. They may look cheap in absolute terms but can be expensive in volatility terms,” says Hekster.

A dynamic approach, shifting between different sorts of hedges to optimize costs based on their relative values and payoffs, is likely to reduce costs over time. This also entails some basis risk between the hedging strategy and the targeted risk reduction so that the strategy could both outperform and underperform the target over different periods.

   The macroeconomic climate is walking a tightrope between recession and inflation and adverse surprises on either could unsettle equities. 

Govert Heijboer, Co-CIO, True Partner Capital

For True Partner, customization comes into play for the design of investor mandates. “Some investors are focused on a single type of tail risk scenario such as protecting against a 2008 or 2020 event. Others are looking to protect against a wider range of market downturns. A third group is seeking a more all-weather hedge fund return profile, but with added convexity. The types and weighting of strategies which best suit investors can differ across mandates,” says Robert Kavanagh, Head of Investment Solutions at True Partner. The firm’s suite of strategies provides options across the full range: “For example, blending tail risk and relative value can be very complementary as the different approaches offer diversification benefits. The beauty of blending relative value and tail risk in one mandate is that over time relative value can generate positive returns which go towards funding more explicit and focused tail risk protection,” adds Kavanagh.

Directional strategies can be combined with relative value approaches in varying proportions. “Individual investors can optimize their balance between the approaches, bearing in mind that relative value in itself can offer some degree of tail risk protection,” says Hekster. A benefit of relative value is that Asian markets can afford more opportunity for cross market relative value trades in the different markets, such as Japan, South Korea, Taiwan and Hong Kong. Each have their own economic and interest rate cycles as well as political and geopolitical sensitivities. There is also scope for relative value trading between continents, which could be US versus Asia or could be three legged including Europe as well. This approach could be applied for relative value trades to find the most favourably priced hedge globally.

A continuum of choices is available. For instance, “A dynamic tail risk approach aims to tactically predict volatility acceleration, and will sometimes pick up false alarms, but can produce an explosively convex payoff when shocks do materialize. In the meantime, it has a small negative cost, but this is lower than a simple put-buying strategy because the protection is conditional rather than continuous. A broader mandate could seek to provide the payoff under both sudden crash and slower drift scenarios, where the payoff would not only come from pure convexity, but also from other portfolio characteristics kicking in. This would be more costly in rising markets, but offer a wider range of protection,” says Hekster. More continuous protection is naturally more expensive and can be tailored to downside volatility scenarios. It can also profit from upside volatility when it becomes depressed.

Monetisation triggers

Even within a pure tail risk mandate – or the tail risk element of a blended mandate – there are choices to be made about monetization frameworks. Do investors want to cash in part or all of their protection at predetermined trigger points, calibrated to equity market moves and/or hedge profits, and then temporarily have less hedges – or even no hedges? Or do they need to maintain some degree of constant protection against more severe crashes?

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The original publication of this article is available at The Hedge Fund Journal, published by Hamlin Lovell on 22 September 2022:
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1. Returns quoted are through July 2022

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