Turn Stock Volatility Into ProfitsI am reminded of the old fund marketer's line:
Turn that worthless client equity into valuable fee incomeFrom Barron's Wall Street's Best Minds column:
Pimco: Turn Stock Volatility Into Profits
A Pimco analyst writes that the market’s gyrations can create alpha-generating opportunities.
Is volatility an asset class? It’s a question we often debate, internally and with clients. There’s no simple answer. Either way, though, it’s an academic point that matters less than our belief that volatility is an “opportunity class” — one with a variety of tactical and macro implications. Moreover, as financial luminaries from European Central Bank President Mario Draghi to Federal Reserve Vice Chairman Stanley Fischer have warned, volatility is likely to rise as the Federal Reserve approaches its first rate hike in almost a decade. Likewise, the opportunities created by volatility are likely to rise in the coming years.
One of the biggest differences between investing in volatility versus traditional “one delta” assets such as stocks or bonds is that volatility investing is about more than simply reaching a final destination for price or income. Profit or loss cannot be determined simply by looking at a traditional chart. If a stock climbs from $100 to $110 over a year, its return is 10%. But if volatility increases from 10% to 11% over a year, the return may or may not be 10%.
Like navigating busy Southern California freeways, volatility option trading is path dependent: Whether one makes or loses money depends on the path taken from point A to point B — as well as what happens en route. As with the freeways, bypassing traffic and finding an optimal route can make a big difference. As a real world example, driving to downtown Los Angeles from Newport Beach can take anywhere from 45 minutes to four hours depending on the route and road conditions (such as, perhaps, unexpected construction). It’s a dynamic process, as volatility — or “traffic” — can create more volatility.
Another key difference is the universe of volatility investors. Volatility market participants generally fall into three categories: hedgers, yield enhancers and relative value (RV) traders. Hedgers buy options (as a form of “insurance”) against their portfolios, which tends to push implied volatility, or the level of future volatility predicted by the option price, above realized volatility, or the actual volatility of the asset over time. Yield enhancers suppress volatility by selling options to earn carry and add to returns. RV traders seek to identify opportunities created by the mismatch of opposing flows of the other two. This mismatch between supply and demand occurs across the spectrums of time, expiry and underlying product.
Historically, banks acted as the “price police.” They were traditionally the biggest RV traders and thus beneficiaries of the flows and imbalances inherent in options trading. However, increased capital costs and regulation have made these once-profitable businesses less viable.
The result: Liquidity has fallen in some markets, prompting sharper price movements and more volatility. And this has provided an opportunity for new RV volatility investors to step in — especially investors who are more concerned with absolute returns, or alpha, than capital-cost-adjusted returns.
Classic volatility strategies
As volatility markets have evolved over the last two decades, a few trading strategies have become common. One is to sell options and rebalance a portfolio position to limit risk (i.e., delta hedging) and capture the difference between implied and realized volatility. Generally, three-month interest rate options trade at about an 8% premium to realized volatility as this is the cost of “insurance” protection....MORE
There is not a whole lot of alpha for managers to divvy up. As I noted in 2013's "My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution":
There's more but you get the point....People, people, people arbitrage opportunities have been disappearing for the past 150 years!
I guessing the two commenters didn't have the definition: "The simultaneous purchase and sale of the same instrument in different markets at different prices" pounded into their head so often their ears bled.
I did.
How many arbitrages do they think present themselves each year?
Spotting and acting on an arb is pure alpha and here is a dirty little secret:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006:
...PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.
Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same....
Here's CBS MoneyWatch in March 2013:
Hedge funds are too big to beat the marketThis is probably just a definitional problem so let's say it plainly:
In so called risk (merger) arbitrage the emphasis is on the first word.
Cash-and-carry, buying physical and shorting a derivative is not arbitrage.
When people use the term "arbed away" when talking about market anomalies the are not talking about an arbitrage.
Shorting an ETF and buying the component equities is not an arb, it's just a hedged trade.
Same for Index Arbitrage.
The total pool of arb opportunities may be as small as $1 billion.
Even the old Royal Dutch and Shell Transport trade was not an arb, just a fairly good pair trade.
The link the two commenters were referring to happened to go through this little blog: "VIX, The End of Arbitrage and the Death of Volatility (VIX; VXX; VVIX)".
It linked at Alphaville to some thoughts by Christopher Cole, a hedgie who specializes in volatility trades.
I'm not sure what Steve and Becky do at the market but I'm guessing from their comments that it is not esoteric volatility trades. Read the darn post.
Next up, I'll deal with another commenter.
Here's Professor Hsieih's Hedge Fund Research page.
Here's some smart commentary on the $30 Billion figure.
See also Hsieh's "The Search for Alpha—Sources of Future Hedge Fund Returns", 11page PDF via the CFA Institute.
Two tautologies:
Hedges are not arbitrage, that's why they're called hedges and all hedges are dirty (imperfect)....
