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True Partner article: Volatility Arbitrage and Tail Risk

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Long, short and neutral volatility and risk management

Volatility strategies can have a long, short, neutral or variable volatility bias, and may have a positive, zero or negative correlation to equities. Most of the time volatility moves in the opposite direction of equity markets but there are notable exceptions: in the 2020 Covid bull market, tech stocks and implied volatility rose together partly due to heavy trading in call options by retail investors and oversized market participants, such as Softbank.

True Partner’s relative value strategies also typically maintain neutral to long volatility exposure. If the opportunity set is less compelling, the team reduces exposure but tends to avoid being outright short.

“True Partner tactically moves between neutral and long volatility stances for all current modules,” says Hekster. “And we aim to bring investors positive surprises. We’ve been doing this for long enough to know that diversification is the only free lunch, and that extreme scenarios sometimes become reality,” he adds.

Investors nowadays have more sophisticated financial tools at their disposal to brave the upcoming storm.

Would True Partner ever consider a short-biased strategy? “There is nothing inherently wrong with short trades,” says Hekster, “we have a lot of experience actively trading both longs and shorts as part of our relative value mandate, you just need to have the right edge and risk controls.” But it is not where the firm is currently seeing the most opportunities. “Most clients now are focused on diversification, which leads to a neutral or long volatility bias. But market opportunities can change. We would be open to creating a customized short volatility mandate if that was truly the best solution for the client.”

Risk management stress tests big moves within and between markets and is agnostic on what their cause might be. Whether the scenario is Covid lockdowns, Russia’s invasion of Ukraine, tensions escalating around Taiwan or a Chinese recession, what counts is that the strategy performs when expected and that risks are effectively managed.

Strategy implementation sub-asset classes

Most ideas are expressed through options on equity indices, though occasionally single stocks can be used. True Partner also occasionally trades other asset classes, such as commodity volatility, when there are particularly compelling opportunities. The team also considers dispersion and correlation trades within equity indices when they reach extremes that present especially asymmetric opportunities.

2022 opportunity set

Different market crises and corrections follow their own paths and patterns, which means that no single hedge is a silver bullet for all scenarios. Trend following CTAs and interest rate volatility are two strategies that have worked well in the first half of 2022, but not necessarily in other periods such as late 2018. Many investors want exposure to a range of diversifying hedge fund strategies and customized tail risk solutions, including those revolving around listed and liquid equity derivatives.

After delivering strong returns in 2020, crash protection has not been so helpful in 2022 as the equity market correction has proceeded in a fairly steady and orderly fashion. The first half of 2022 has been distinguished by both equities and implied volatility dropping in tandem; the two tend to be inversely correlated most of the time.

This phenomenon has been seen across multiple equity markets in the US, Europe and Asia. “This is unusual but not unprecedented: in the early 2000s after the dotcom bubble burst, markets started with a fairly slow growth to value rotation before broadening out to a wider market selloff. Similarly, in the summer of 2008, it took some time for equity volatility to react,” recalls Hekster. If investors initially rotate from growth to value stocks, a low or sometimes inverse correlation between the two groups can help to calm down overall equity index volatility. “In 2017 the VIX was low for a long time before exploding in 2018. We can take a view on the volatility of volatility itself through instruments such as options on the VIX, which offer double leverage. The VIX itself already offers some leverage to equity market declines, and options on the VIX can further amplify this,” says True Partner co-CIO, Govert Heijboer.

The first half of 2022 has not been conducive to tail risk because there was not a convex move down, so pure equity tail risk hedges provided very little protection. Relative value has also had a limited opportunity set, in part due to low volatility of volatility. The index option markets in July 2022 have calmed down to a state that could leave value in certain dimensions of the volatility surface, such as skew, or volatility of volatility, which has dropped to pre-Covid levels. This could create more headroom to profit from any dislocations.


“In some way equities have been the odd one out so far this year,” says Hekster. “We have seen volatility rise in fixed income, currencies and commodities, but equity index volatility has remained quite subdued.” The lack of volatility moves is perhaps most tellingly illustrated by looking at strategies that sell tail risks: a simple strategy of selling out-of-the-money puts on equity indices to earn premium – the opposite of hedging – would have profited year-to-date, while the same strategy would have had substantial losses in the prior downturn in Q1 2020. This has made the first half of the year somewhat frustrating for equity volatility specialists, but from a forward-looking perspective the picture is more positive. “Equity tail risk hedges now appear cheaper than other asset classes, though you do still need to be selective as hedges generally are not cheap in absolute terms,” says Hekster.

There has been some variation between market performance this year, but less so in volatility behaviour. The market variations can help explain part of the limited volatility reaction, as there has not yet been a ‘panic’ moment at the global level, a feature often seen in downturns. Indeed, the last month the world’s major equity markets all had a negative return was back in March 2020 – that’s the longest gap since just before the “Volmaggedon” event in February 2018 when the VIX rocketed higher over a few days. Hong Kong’s markets in particular have had a close to zero correlation to US and European markets this year, while the Nikkei is only down 3% in local currency terms (though the yen depreciation would make US dollar-based returns somewhat worse). In Europe, the FTSE 100 remains up for the year.1

“There are some sound fundamental reasons for divergences,” says Hekster. “Europe has been harder hit by the Russian war and growth and inflation dynamics differ. Sectoral compositions also matter, while currencies have absorbed some of the differences in places like Japan. But as we approach a recession amid global monetary policy tightening and an energy price shock, there are echoes of 2001/02, 2008 and other historical downturns. We expect this to result in supply and demand dislocations in volatility over the coming year.” Heijboer also points out that diverging policy responses can themselves help lead to dislocations. “Divergence between policies could also create opportunities as they can lead to imbalances. The US is raising rates rapidly, Europe is raising rates haphazardly, and Japan is not raising them at all. Meanwhile China is trying to keep the economy going while maintaining its zero Covid policies and managing a real estate downturn.”

The firm sees potential for increased equity volatility over the coming months: “A possible disconnect between wider corporate credit spreads and lower implied volatility could throw up opportunities for some reconvergence between the two, which are normally interlinked. And a cathartic capitulation in equities with big shifts in asset allocation has not yet been seen,” says Hekster.

Beyond wider credit spreads, Heijboer sees a coalescence of multiple unprecedented events in 2022: “We have the highest inflation since the 1970s. Interest rates are still around zero in Europe and Japan. We have the aftermath of the Covid crisis. And energy supply problems catalysed by Russia’s invasion of Ukraine are leading to cost increases of 100% or more in some countries that are now feeding through to a broad range of production costs. All of this has happened very quickly”.

Against this backdrop, it is perhaps surprising to see equity volatility at relatively subdued levels. “If events turn out to be more severe than people expect there could be some nasty surprises for equity investors. European equity implied volatility is slightly higher than in other regions, but it is not pricing in risks including energy related inflation, or fragmentation risks such as a country deciding to abandon the euro. The next leg down in markets could be bigger. In the early 2000s, the decline started slowly and then accelerated,” recalls Heijboer. “In certain equity markets such as South Korea, implied volatility has fallen by as much as 50% and even dropped to below long-term averages. One cause of this could be structured products selling options,” he adds, “we’ve seen before that this buying can go into reverse if the environment shifts quickly.”

Geopolitical tensions could also spark off equity market volatility, potentially in Taiwan, the South China Sea or elsewhere, and the economy is also in uncharted waters: “The macroeconomic climate is walking a tightrope between recession and inflation and adverse surprises on either could unsettle equities,” says Heijboer.

Sensing opportunities ahead, True Partner has been expanding its team over the last 12 months, investing in research. “We are confident that volatility markets will provide an attractive opportunity set for investors in the coming years,” notes Hekster. “We have been able to make some great hires in areas like quantitative research, expanding our bandwidth and giving us opportunities to grow in adjacent markets.” As we approach an uncertain market environment, this could also be a good time for savvy investors to revisit the volatility space.


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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