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Harvesting the S&P500 Volatility Risk Premium

The ultimate goal of an investor should be to identify and exploit attractive risk premia in capital markets. Risk premia and factor exposures have been intensively discussed in academic literature as a framework for decision-making processes in the area of Absolute Return and Hedge Fund investing. However, to practically extract a risk premium and to offer market participants an attractive investment opportunity requires a very structured approach. This article provides an insight on how to efficiently harvest the volatility risk premium in the US stock market (S&P500) through a regulated (UCITS IV) investment vehicle (OptoFlex I - ISIN: LU0834815101).

We define the attractiveness of a risk premium by its magnitude, stability and liquidity. Magnitude measured as the expected return implying whether a certain risk should be considered to be taken by an investor to receive a premium. As drawdowns of an investment should be minimised, the stability of a risk premium is important as well. Sufficient trading liquidity of a risk premium is also required to provide flexibility for potential exposure adjustment in case desired. Assuming that an available risk premium combines all three of the above we expect an investor to be adequately paid for taking such a risk in capital markets.

Below we demonstrate that the volatility risk premium in the US stock market (S&P500) is characterised by all three criteria defined above. The return expectation from harvesting the volatility risk premium is not only attractive in terms of the dimension, but also very stable in comparison to other capital market risk premia. Finally, the S&P500 volatility risk premium can be captured very efficiently in the most liquid derivative markets globally.

Finisterre Emerging Markets Macro UCITS Strategy

Finisterre’s emerging markets macro UCITS strategy won The Hedge Fund Journal’s UCITS Hedge award for best risk-adjusted returns over a three-year period ending in 2016, in the emerging market macro category. Finisterre was founded in 2002 and the firm, which runs approximately $3 billion and belongs to The Hedge Fund Journal’s “Europe 50” ranking of the largest 50 hedge fund managers in Europe (including the UK), launched the UCITS in 2013. Its investment objective is to generate absolute returns, while controlling volatility, within a robust risk framework. While Finisterre does run separate long-biased EMD strategies, the macro UCITS strategy has no long bias nor any requirement to generate positive carry. It can be net short, and/or can run with negative carry. For most of its history since 2013, the strategy has stayed within a relatively narrow range of interest rate, and credit spread, sensitivity as shown in Fig.1.

Interest rate and credit spread sensitivity
Like all Finisterre strategies, the macro UCITS employs an active and unconstrained investment approach, and for this strategy benchmarks or indices are not relevant. Thus the strategy has a broader, and more flexible, mandate than some emerging markets UCITS strategies. It employs a dynamic and opportunistic mix of long, short and relative value trades, taking views on individual countries’ government bond, interest rate, currency and occasionally equity, markets, in both emerging and developed economies.

Goldman Sachs Global Multi-Manager Alternatives Portfolio

The Goldman Sachs Global Multi-Manager Alternatives Portfolio (GMMAP) received The Hedge Fund Journal’s UCITS Hedge award for “Best Performing Fund in 2016 (Multi-Manager - Liquid Alternatives category)” over a one year period ending in December 2016, based on its risk-adjusted returns. In absolute terms, GMMAP has also performed well, outpacing the HFRX Global Hedge Fund Index, as shown in Fig.1.

“We designed the product to offer investors access to a diversified, multi-strategy portfolio of high quality hedge funds and other investment managers, with daily liquidity and appropriate fees,” says GSAM Managing Director, Robert Mullane, who sits in Goldman Sachs’ London offices on Fleet Street. GMMAP assets have already doubled to $600 million since this particular product was launched in December 2015. Additionally, the start of the GMMAP strategy, managed by the Alternative Investments & Manager Selection (AIMS) Group, conceptually dates back to 2013, “when we launched the same strategy for GSAM’s US clients,” Mullane recalls.

The US strategy, which is run from New York by Kent Clark, Betsy Gorton and Ryan Roderick, currently contains eight of the nine managers in the UCITS. The GMMAP strategy was more of a product evolution than a fresh launch. It might seem bold for GSAM, which has been structuring UCITS for over 20 years, to have jettisoned its award-winning former fund of alternative UCITS funds. The firm felt that a fairly radical restructuring of the fund of funds business model was timely. “We wanted to evolve to a more innovative solution, and it has been well received by third party distributors, private banks and even pension funds,” explains Mullane.

Ballymena Soft Commodities Strategy

Have commodities had a capitulation moment? Several banks (Barclays, Deutsche Bank, JP Morgan) have ceased making markets in them, multiple funds have shut down, and some investors have also thrown in the towel. Yet some of the most seasoned commodity market traders have a more constructive outlook: “You do not need another boom and bust period like the one we saw from 2001 to 2011 to find compelling investment opportunities,” says Ballymena’s lead Portfolio Manager Oliver Kinsey.

Ballymena is an actively managed agricultural commodity hedge fund, which trades opportunistically on the long or short side. At the present time, however, Kinsey views commodities – even from a long-only angle – as relatively attractive. Kinsey reckons “the chances of heightened volatility in traditional asset classes (equity and fixed income) is certainly rising and we may even see an equity market correction. There are only two instances in history of a longer bull run for the S&P 500 without a 20% correction. One ended in 1929 and the other when the tech bubble burst in 2000. We are not necessarily predicting an implosion of traditional asset classes but feel they inevitably see much greater two-sided volatility in the future, a scenario where macro and commodity specialists could do relatively well.”

It may have gone somewhat unnoticed but commodity long-only indices were up in 2016 and the tide could certainly be turning for this space.

Kinsey sees scope for CTAs and long/short discretionary commodity trading funds to generate “crisis alpha”. But commodities can also thrive in more benign financial markets and could perform well even if equities continue melting up. “Equities are on a sugar rush after Trump, but if the reflation story is true, then that is very good for commodities in general,” Kinsey argues.

Profile: Christopher Hilditch

Schulte Roth & Zabel (SRZ) investment management partner Christopher Hilditch was recognised for his “Outstanding Contribution” to the industry at The Hedge Fund Journal’s 2017 Awards event, during which the firm also received the “Best Global Law Firm” award. Hilditch and SRZ partner Josh Dambacher serve as co-heads of the firm’s London office, which was opened in 2002. A pioneer in the alternative investment management industry, SRZ was founded in 1969 and is headquartered in New York City.

At school, Hilditch had contemplated a career in the British Army, before work placements at law firms piqued his interest in the legal profession. After studying Classics at Oxford University’s Pembroke College, Hilditch joined Simmons & Simmons, which sponsored his law conversion course and solicitor training. Six years after qualifying, the precocious offer of a partnership and heading up a funds practice lured Hilditch to another firm, but only two years after that, in 2002, he was singled out for an opportunity that was too good to pass up.

At that time, SRZ had planned to set up a London office, and “there were only two other law firms that were really active in the London hedge fund market, where the European industry was just beginning to expand rapidly,” he recalls. Hilditch anticipated SRZ’s subsequent success, surmising that “as SRZ was exceptionally well known in the US, it had the pedigree and reputation to make a difference in London.”

Transtrend

Transtrend started life in 1989 as a research project in a Rotterdam-based commodity trading house, but swiftly joined the ranks of the world’s largest CTAs. It is one of the 20 CTAs making up the BarclayHedge BTOP50 index and is a constituent of two Société Générale Prime Services indices: the SG CTA index and the SG Trend Index. Assets of around $5 billion make Transtrend the most sizeable hedge fund manager in the Netherlands, and the firm belongs to The Hedge Fund Journal’s “Europe 50” ranking of the top 50 hedge funds in Europe (including the UK). “But Transtrend’s aim has always been to be among the best and not the biggest,” says Head of R&D and Managing Director, Harold de Boer. Transtrend is distinguished from other CTAs by qualities including its performance; investment universe; ways of defining markets and trends; in-house research process and preferred statistical and risk management techniques.

Dangers of passive investing
De Boer is an advocate of active management and his iconoclastic perspectives could shift the active versus passive debate into new directions. It is common to argue that active management adds value for less liquid and less efficient asset classes (such as commodities, small cap equities, credit or emerging markets) whereas passive approaches win out for larger and more liquid asset classes (such as large cap equities). De Boer thinks that the entire index mentality is fundamentally flawed however and calls for what might sound like a new paradigm – but is in fact a return to the original way of investing. “The average fund in the 1920s was genuinely active, unconstrained and was in effect what nowadays is called a hedge fund,” he points out.

Advent Capital Management Marks 20 Years

Advent Capital was founded in 1996 by Tracy V. Maitland, who had previously been a director in the convertible securities department of Merrill Lynch (now BAML). Today Advent runs just over $9 billion with some strategies exclusively focused on convertibles, while others allocate across the capital structure. The asset manager has steadily diversified into three synergistic business areas: it manages roughly $7 billion in long-only funds, primarily investing in convertibles (with some straight high yield debt); over $1 billion in three closed-end funds listed on the NYSE, and approximately $400 million in alternatives, including absolute return funds, hedge funds and liquid alternatives.

Of 60 staff, mainly in New York and London, 25 are investment professionals, whose original corporate research is the core Advent competence running through all business areas. “The analyst team cover sectors, sub-sectors and geographies. They use both sides of the brain in analysing income statements and balance sheets,” says Advent COO, Kris Haber. Joined-up thinking means that the team spans the whole capital structure, including straight debt, convertibles and equity. The synergy among the business sleeves is garnered by the applicability of this research to any of Advent’s existing investment strategies and vehicles, or indeed the new ones being rolled out. “By understanding the various components across the capital structure, you are more knowledgeable about relative value, and long and short opportunities that exist,” Haber says.

Algebris Macro Credit Fund (UCITS)

Investors seeking exposure to fixed income and credit can select from a wide variety of strategies and vehicles, ranging from passive index-tracking products, such as ETFs, to benchmark-conscious long-only funds, absolute return funds, total return funds, hedge funds, structured credit vehicles and even private equity funds.

Algebris manager Alberto Gallo argues that “a relatively unconstrained approach, with flexibility to express macro views and invest long or short across a wide range of liquid rates and credit asset classes, is essential for the macroeconomic and financial market landscape of early 2017 where government bonds offering very low or negative yields are clearly a source of huge negative convexity.”

Indeed, Gallo’s UCITS fund, which has so far raised $400 million, is up 5% since inception in July 2016 and has already profited from a core 2016 theme of shorting government bonds, before rotating to reflation trades this year. He thinks that a traditional, long-only, benchmark-constrained strategy (that can only over-or under-weight sectors or securities) would be a straitjacket. Such semi-active strategies, subject to tight tracking error constraints, have been dubbed “closet trackers” and face competition from passive tracker products, such as ETFs, which Gallo views as “cheaper, but vulnerable to herd behaviour and low returns.” Therefore he envisages that “only low-cost or genuinely active strategies with many degrees of freedom over asset allocation and security selection will survive.” Performance to date, versus peers identified by Algebris, is shown in Fig.1.

CTA Kaiser: 19 Years of Evolution

Kaiser, which has offices in Melbourne and London, returned 10.28% for its Kaiser Global Diversified Program’s Class A in 2016, a year when the average CTA was slightly down (the SG CTA index ended 2.86% lower). This disconnect is not unusual: the programme has a low correlation with the BarclayHedge BTOP50 index, with an average historical correlation of 0.3.

“We trade over different time frames, which provides a sound reason for our low correlation,” explains founder Tony Kaiser. The programme’s median holding period is three days, hence the SG Short Term Traders Index – up 0.31% in 2016 – is is another benchmark, which could complement broader CTA indices that can include long-term, medium-term and short-term technical CTAs, not to mention some systematic and quant macro funds that use fundamental data. Indeed, Kaiser’s peer group CTAs are sometimes defined as other short-term traders, such as Amplitude, Boronia (also headquartered in Australia), Crabel, R.G. Niederhoeffer and QuantMetrics.

This does not imply that Kaiser has a similar return pattern to these managers, however. Correlations within the short-term trader universe are lower than the coefficients between medium- and long-term CTAs. As well as ploughing their own return profiles, short-term traders tend to pursue differentiated approaches, in terms of philosophy, process, execution techniques and risk management. Here we outline some of Kaiser’s distinguishing features.

Andurand Sees Further Energy Recovery

Andurand’s 6.8% return in December 2016 took full year returns up to 22.1%. The fund is now up 110% since its inception in February 2013 for new investors (or 127% for those in a legacy share class that carried over the high watermark from Pierre Andurand’s former fund, BlueGold). Meanwhile the oil price, measured by the S&P Crude Total Return Index, has declined 66% over the same period. Pierre Andurand’s cumulative performance of more than 3,600% since he started trading, greatly outperforms the comparable S&P Crude Oil Total Return Index, which returned -79% in the same period. Andurand featured in The Hedge Fund Journal’s biennial “Tomorrow’s Titans” survey back in 2010, sponsored by EY.

Tactical trading and technicals
Though Andurand did put on a range of energy market relative value trades in 2016 (which largely account for gross exposure above 200%), and can, but did not, trade metals and currencies, it was directional calls on the oil price that accounted for nearly all profits last year. This is typical of the career of a man who has participated in all of the big moves in oil prices. A history of Andurand’s directional calls since 2004 is illustrated in Fig.1. He estimates that he has, on average, captured around 70% of each move.

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