Volatility & Tail-Hedge – Update After COVID-19

All-Weather Returns and Tail-Risk Protection

After a historic 10-year bull run, the world and global markets were suddenly forced to deal with a worldwide pandemic that is known to all of us as COVID-19. Globally, the macro picture was looking decently good, as company earnings growth appeared healthy, and equity market valuations remained attractive, particularly relative to cash and fixed income. But here comes the but…

To be a careless risk-taker was en vogue. And what now?

The cheap money fueled by low-interest rates, led to investors becoming irrationally exuberant and increasingly careless. Even professional allocators have started to turn a blind eye towards the fact that, the longer this party lasts, the harsher the reality might be. Unless you can consider yourself amongst the well rewarded in this crisis and walk out of it as one of the probably few winners. As we mentioned in one of our very first blog posts, as a successful market participant, you start planning ahead for rougher times.

Does that mean great returns can also be achieved in difficult markets? It certainly can, and the proof of concept has been delivered.

Traditionally, installing any decent level of portfolio protection either meant buying put options or going into cash. The first method can be expensive and is somewhat frowned upon by professional investors. The latter, particularly if it lasted longer than a few days, would get any professional money manager into the delicate situation of not only having to explain why they charge fees for cash management but also the impact of negative interest rates on that cash! So, which option is left?

“By partnering with the brightest minds in the volatility & tail-hedge strategy space, we can offer access to negatively correlated strategies, and thus protection, in difficult markets.”

– Andreas Bezner, CEO at Stableton

The approaches we have been focusing on trade quantitatively in the volatility asset class to harvest the volatility risk premium systematically. Also, they trade global equity index futures to benefit from big moves in equity markets. Some other strategies employ (covered) option strategies together with short-term momentum trading. This approach limits the downside risk but can significantly participate in huge profits when volatility surges. In a portfolio context, these types of strategies result in a negative correlation to equities and other asset classes, as we proofed in this COVID-19 crisis.

What is Volatility?

Volatility is a statistical measure of the variation of asset prices over time. The market typically differentiates between two types of volatility: realized volatility and implied volatility. Realized volatility is a backward-looking measure of price variation calculated as the standard deviation of historical returns over a specified period. Implied volatility is a forward-looking measure of expected price variation that is implicit in market prices of options.

The Cboe Volatility Index® (VIX® Index), or sometimes referred to as the “fear” index, for example, measures the implied volatility of the S&P 500 Index® (SPX) option prices. While the index itself is not directly investable, there are liquid futures and options available.