The hedge fund industry uses a diverse range of securities and strategies to trade volatility globally. Funds adopting this trading approach aim to exploit the volatility of the price of an underlying investment rather than the price itself. Preqin’s Hedge Fund Analyst online service currently tracks 237 funds which trade volatility.
Preqin’s performance benchmarks show that volatility trading funds have demonstrated a good level of consistency over the past few years; the volatility benchmark has returned 8-9% in each of the four years from 2010-2013. The five year annualized returns of 8.59% for volatility trading funds trail the overall hedge fund industry average of 11.72%, however the strategy has shown a greater ability in terms of protecting capital during adverse market conditions. In 2008, when high levels of market volatility saw the industry make a loss of 16.90%, volatility trading funds were able to ride the storm to deliver gains of 14.15%. Additionally, when global markets again faltered in 2011, volatility trading funds returned an average of 7.63% (compared to the industry average of -1.69%).
The relative safety of volatility funds is further highlighted by a comparison of Sharpe ratios and volatility levels. As of 30 April 2014, volatility trading funds had a five-year Sharpe ratio of 3.82, a significant trump in terms of risk-adjusted returns when compared with the 1.65 posted by the industry as a whole over the same time period. For more risk-averse investors, a five-year volatility level of 1.72% for volatility trading funds also compares favourably with the industry average of 5.90%.
On average, funds trading volatility offer better redemption terms when compared to the wider industry. At 27 days, the average redemption frequency for a volatility trading fund is significantly lower than that of the industry as a whole (38 days). Redemption notice periods are also more favourable for investors, with volatility funds and the overall industry averaging 27 days and 34 days respectively. These figures may again demonstrate a more attractive opportunity to the risk-averse investor due to the fact that they can access their capital on a more regular basis.
Trading volatility is a technique that is practiced globally. The geographic breakdown of hedge fund managers adopting this strategy is broadly reflective of the breakdown for the industry as a whole, indicating a consistent appetite across regions. Sixty-percent of funds that trade volatility are managed by firms headquartered in North America. Europe-based managers run 29% of volatility funds, perhaps showing a slight affinity for the strategy given that they manage 21% of all active hedge funds. Managers based in Asia-Pacific and other regions outside North America and Europe manage 8% and 4% of volatility funds respectively.
Preqin’s performance benchmarks can help to highlight the capabilities of different strategies in varying market conditions. While volatility trading may not post the home run numbers sometimes seen by strategies such as long/short in favourable market environments, the data over the past few years has proven this strategy to be a notable provider of capital protection and consistent positive returns.