The increased volatility in global markets over recent weeks, as well as corrections in US and UK equity markets, may have led to short-term difficulties for a number of hedge fund strategies. However, hedge funds which use derivatives to trade volatility may be poised to benefit from these changes. Using data on 302 hedge funds trading volatility as profiled on Preqin’s Hedge Fund Analyst, we look at the growing interest among hedge fund managers in volatility trading and the potential benefits offered by these strategies.
The number of launches of volatility hedge funds has increased significantly over the past few years. Following strong performance in the challenging years of 2008 and 2011, the number of new fund launches trading volatility jumped significantly, despite a dip in 2010 – as shown in the chart below – and peaked in 2013 with 49 fund launches, compared with 17 in 2008.
The returns of volatility hedge funds tend to be considerably less volatile than other hedge fund strategies, with a five-year volatility of 2.08% compared with 4.83% for the Preqin All-Strategies Hedge Fund benchmark. This has contributed to a higher five-year Sharpe ratio (risk free rate = 2%) for hedge funds trading volatility: 2.09 compared with 0.91 for hedge funds as a whole.
Volatility trading styles have also performed particularly well during the years in which hedge funds performed poorly overall: in 2008, hedge funds trading volatility were up 8.84%, compared with a fall of -17.39% for the Preqin All-Strategies Hedge Fund benchmark. Similarly, in 2011, these funds rose 6.63% as the hedge fund industry as a whole fell by -1.74%. However, over the three- and five-year horizon volatility funds have underperformed, posting 4.69% and 6.36% respectively, compared with the All-Strategies Hedge Fund benchmark’s 6.59% and 6.38%. Over the 10-year horizon volatility trading funds achieved an annualized return of 10.53%, compared with 8.95% for the Preqin All-Strategies Hedge Fund benchmark.
Recent concerns over China and stock market turmoil have led to a spike in volatility. While such an environment could prove difficult to navigate for hedge funds, volatility trading hedge funds could also stand to gain, in consideration of their proven track record in uncertain years.