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Volatility hedge funds have had a banner year due to the recession triggered by the COVID-19 pandemic. The CBOE Eurekahedge Long Volatility Hedge Fund Index returned 27.37% for the first eight months of the year, compared to the -10.87% return it posted for all of 2019.
On the other hand, the Eurekahedge Hedge Fund Index, which includes all strategies, is up only 3.75% for the first eight months.
What are volatility hedge funds?
So what makes volatility hedge funds so different from other hedge fund strategies? It's the fact that they are essentially a bet against a strong economy, while other strategies depend more heavily on a strong economy. Many investors understand the role hedge funds and other alternative assets play during a recession, as data indicates they have been increasing their allocations to alternatives.
The long volatility strategy bets on the markets being volatile, which means it doesn't do well when the markets are moving up, up and away like they did for more than 10 years. Thus, this strategy is negatively correlated to a growing economy, while stocks, fixed income, real estate and private equity are all positively correlated to a growing economy to varying degrees.
Many hedge funds position themselves for a long volatility strategy when they believe the economy is heading into a recession.
Using volatility funds to diversify
In a recent study, the CAIA Association explained that volatility hedge funds offer a way to diversify your portfolio. Shorting volatility is highly correlated with stocks because both depend on the market moving higher.
The HFRX Volatility Index had a low correlation with stocks until the end of 2018. At that time, it spiked, which could suggest changes in styles or constituents of the index. It's important to note that the index includes all volatility strategies, including long, short and neutral volatility.
Long volatility hedge funds were particularly good for diversification because they have the lowest correlation to the S&P 500. However, the CAIA Association pointed out that the negative correlation has been declining steadily since 2004.
Why hedge funds might not be the best option to go long on volatility
One problem is that hedge funds charge performance and management fees, but there are less expensive ways to bet on volatility, either on the long or short side.
Aside from going long on volatility, two other ways to get similar effects are to short the S&P and to simply reduce equity exposure. Both strategies are less expensive and easier than going long on volatility through hedge funds.
Another way to get similar effects is to use options or options-based indices, which are widely available as less expensive exchange-traded funds. These ETFs also tend to be more transparent on what's included in their portfolio.
What happens when a volatility play is added to a portfolio
The CAIA Association then simulates what adding a 20% allocation to volatility strategies to a U.S. stock portfolio would do to the portfolio. They found that the risk/ return ratio increases, while maximum drawdowns for all volatility strategy types decline.
Interestingly, even short volatility strategies added diversification to the portfolio despite their correlation with stocks. However, the researchers pointed out that there is risk investing in volatility, especially since history tells us that bull markets tend to last longer than bear markets.
The risk of investing in volatility is increasing as the world's central banks are now stepping in at the slightest hint of economic turmoil or market volatility. Stimulus measures and quantitative easing tend to boost the markets, reducing the length of bear markets.
Volatility hedge funds may offer an attractive way to diversify your portfolio, especially if other volatility strategies seem to difficult to implement. Options-based strategies in particular can be tricky, although ETFs can provide an alternative method.
About the Author
Michelle Jones is editor-in-chief for ValueWalk.com and has been with the site since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She has experience as a writer and public relations expert for a wide variety of businesses. Email her at Mjones@valuewalk.com.
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