Tuesday, August 30, 2011

"The cost of a crowded volatility trade" (VXX; XIV; TVIX)

From FT Alphaville (now with new comment policy!):
FT Alphaville just had a very interesting conversation with Ari Bergmann, managing principal at Penso Advisors, with respect to what’s been happening in the world of volatility hedging this year.
And specifically how things have changed since July.

Two points stand out:

1) There’s not been much of a risk/reward in equity-related volatility hedging strategies at any point this year (or post-2008 for that matter).
2) The volatility hedges that made a lot of sense pre-July 2011 were mainly in interest rate, CDS and money market instruments. All of these, however, have since lost their allure due to a major re-pricing of risk in the market this summer.

With respect to the first point, Bergmann is essentially saying that any “black swan” hedging strategy focused on equity options or Vix futures would have proved hugely expensive and thus unsuccessful:
Unless you got the timing right and the levels right it would have been far too expensive. The risk/reward hasn’t made sense. Once the risk is priced in you’re not getting anything for it. It becomes like a trade. You are sure to lose money unless you get your timing right.
The point here is that the “giveup” in terms of the pricing of the insurance proves more expensive than the potential insurance you receive in return.

Currently, says Bergmann, December put options are priced in such a way that you would need a move of 17.4 per cent or more to the downside to break-even on the trade. That’s hardly worth anyone’s while, he argues.

The Vix curve, meanwhile, is a good example of just how crowded and expensive the Vix trade itself has become. For most of the year, the steep contango was reflecting the fact that insurance sellers could command unreasonably high risk premiums in return for the insurance they were offering...MORE
Erratum: In the sentence below I had originally said Roubini instead of Taleb until a pair of younger eyes caught the mistake and supplied the links. Sorry about that.

And that, boys and girls is the problem with Black swan funds and why Taleb lost (risk adjusted) money running his fund.
As Falkenblog put it:
...So after the fund starting grinding out losses, Nassim started calling his fund a 'hedge', not a fund, later, a 'laboratory'. Now he says about the fund:
`Our aim was not to make money,'' Taleb says. ``I make no claims of being able to beat markets.'
But he makes sure any article that mentions his fund notes he made 60% in 2000. The only record of his total fund was a WSJ article on him in 2007, which notes he lost money in 2001 and 2002, made single digits in 2003 and 2004. That averages out to around 12%, and as the risk free rate was about 4% over that period, and the volatility was probably around 17% on a monthly basis, thats a Sharpe of 0.47. Not so good. And that's with his unaudited returns, so it's probably biased high (people have a tendency to round unaudited results upward significantly).
Taleb Makes Hyperinflation Bet and Why You Might Want to Be Skeptical
More on Nassim "Black Swan" Taleb as a Money Manager