Institutions beginning to handle volatility by trading it

LONDON — If you can’t beat it, trade it. That approach toward volatility is increasingly making inroads among institutional investors, including pension funds such as the $275 billion Stichting Pensioenfonds ABP of Heerlen, Netherlands. Officials at ATP, the $66 billion Danish labor market supplementary-pension-fund scheme in Hillerod, Denmark, also are considering better ways to manage volatility in order to diversify the portfolio, protect capital and enhance yield, said Henrik Jepsen, chief investment officer of the fund’s beta portfolio. “One of the things we’re very conscious about is that there’s too much dependency on equity returns for our portfolio performance,” he said. “A potential problem for us remains a major fall in the stock markets.” Volatility nipped investors Feb. 27 when a market correction that started with the Shanghai Stock Exchange rippled across the globe. The Dow Jones Industrial Average lost 3.3% — the steepest decline since Sept. 11, 2001, wiping out more than half a trillion dollars in market value. Added stability While many managers and pension funds held steady during the turbulence, the events prompted a re-examination of the role of volatility management within an investment portfolio. Because of its low to negative correlation with equity markets, volatility investing can be used to inject stability into a portfolio both in an absolute sense and relative to liabilities, said Serkan Bektas, managing director and head of European pension solution structuring at Barclays Capital in London. “What we’ve observed is that volatility is emerging as an underlying market strategy on its own,” he said. The size of the volatility trading market is difficult to gauge, partly because a significant portion is done through the over-the-counter market, and therefore, statistics are not publicly available. But an increase of closed-end funds using volatility management strategies indicates sizable growth in the market. Assets under management in such funds were estimated at $28 billion at the end of February, compared with about $2.2 billion at yearend 2004, according to data from Volaris, the New York-based volatility management division of Credit Suisse Securities (USA) LLC. While a few pension funds have relied on options to implement their views on volatility, the ability to extract that volatility and trade it is relatively new, said Kevin Carter, managing director and head of New York-based JPMorgan Chase & Co.’s London-based pension advisory group for Europe, the Middle East and Africa. “Historically, when they bought and sold options, [pension fund trustees] understood that volatility is embedded, but they never had the ability to buy and sell that volatility until very recently,” he said. “The number [of pension funds] considering volatility trading is still very small. I would be amazed if it will ever become run-of-the-mill.” Using volatility management to protect the downside of market shifts also has its drawbacks. A concern Mr. Carter raised involved a scenario in which the stock market slowly “grinds down over a long period of time.” Panacea for panic “In that sort of market, volatility may go down just as the underlying equity portfolio is going down,” he said. “But in a sharp, panicky decline like the one we just saw, volatility will act in the opposite direction — and that’s when it can be a good hedge.” Gareth Derbyshire, managing director and head of the pension advisory group at Lehman Brothers International (Europe) in London, added: “Another way to think about it is as a diversifier.” He said that some pension funds have allocated up to 3% of total assets to volatility investment strategies, usually as part of their alternatives portfolio. These mandates can be executed on a notional basis, typically using swaps, so that little actual funding is required. Mr. Derbyshire declined to identify the funds that are active users of the strategy Options-pricing models such as Black-Scholes helped set the foundation for volatility management. Call and put options are most commonly used to hedge against abrupt volatility shifts. But as investors become familiar with volatility-linked derivatives, they are seeking other ways to profit from the implied volatility forecast relative to their views on the underlying volatility expected over the life of the option. One approach is to trade volatility futures contracts linked to indexes such as the Standard & Poor’s 500 stock index, the Dow and Euro Stoxx 50. These short-dated volatility futures contracts can help improve returns at a reduced volatility to the underlying equity portfolio, said Stuart Rosenthal, vice president and portfolio manager at Volaris, which had $5 billion in notional assets under management as of Dec. 31, up from about $1 billion three years earlier. For example, the Chicago Board Options Exchange’s CBOE S&P 500 2% OTM BuyWrite index — a benchmark index that theoretically sells monthly call options in which the strike price is 2% higher than the market value of a portfolio of stocks in the S&P 500 — produced an annualized return of 12.5% between June 30, 1988, and Feb. 28, 2007. During the same period, the S&P 500 recorded an annualized return of 11.6%. “What’s important to note is that these returns are at a fraction of the volatility of the S&P 500,” Mr. Rosenthal said. At ATP, put options were introduced last year to hedge against market shifts linked to certain portions of the fund’s U.S.-dollar- and euro-denominated equity portfolios, which total about $7.8 billion. Pension fund officials are contemplating expanding the fund’s volatility management strategy, possibly to include the use of “pure volatility instruments” such as variance swaps, Mr. Jepsen said. A variance swap is an over-the-counter derivative used to exploit the difference between implied volatility and realized volatility over a period of time. Variance swaps Variance swaps are featured in ABP’s volatility trading program, which was launched in 2006 as part of its global-tactical-asset-allocation strategy, managed both internally and externally. The program has since expanded because of return opportunities “driven by spread developments in the volatility space and in the underlying markets,” said Gerlof de Vrij, head of GTAA for ABP Investments, the fund’s asset management arm. He declined to say how much money that ABP had so far committed to the volatility trading strategy. “Often spreads increase following higher levels of volatility, thereby creating better opportunities,” Mr. de Vrij said. “Apart from that, we are also building up in-depth derivatives knowledge as a spinoff and looking to expand our set of volatility strategies.” ‘Less costly’ approach Once considered an esoteric tool for hedge funds, variance swaps are gaining credibility as a way to profit from volatility in a “more efficient, transparent and less costly” manner, Mr. Rosenthal said. Other volatility trading methods seek to profit from the differences between the volatility of a particular index and its constituents. Arbitrage, or relative-value, strategies exploit volatility mispricing among correlated, but different, underlying assets. Still others extract returns from mispricing among the same underlying assets. Asset managers predict that volatility trading strategies will become a more important investment tool in the coming years. Ronald Egalka, president and chief executive officer of Boston-based Rampart Investment Management Co., said: “First on our dance card” is to incorporate a [CBOE volatility index] option or futures tactic. “We’re at an early stage of our testing of these concepts,” said Mr. Egalka, whose firm manages about $15 billion in assets, mostly for institutional clients and affluent individuals. Rampart’s focus is on the classic covered-call-writing strategies. As a way to counter the effect of a significant decline in the stock market, VIX futures contracts can be used instead of market index put options, because they are more cost efficient. Currency volatility JPMorgan Asset Management recently introduced a G7 currency volatility trading strategy with about $150 million in assets under management. “It’s similar to isolating currency as a source of risk and a potential for return, only this involves volatility,” said Robert Stewart, a JPMorgan vice president, who is head of currency management in London. “It’s one element within a suite of alpha modules, each with a low correlation to another.”