Volatility Hedge Funds Outperform Industry First Time Since '03

By Saijel Kishan and Jeff Kearns

Sept. 9 (Bloomberg) -- Hedge funds that profit from turbulence in the financial markets are beating stock, bond and commodity investments for the first time in five years.

Volatility hedge funds climbed 7.3 percent this year through August, according to the Newedge Volatility Trading Index. The average equity fund fell 8.38 percent, corporate fixed-income funds declined 4 percent, and energy and basic- materials stock funds dropped 6.36 percent in the same period, data compiled by Chicago-based Hedge Fund Research Inc. show.

``Nobody knows the direction of the markets or economy at the moment, and we're profiting from that uncertainty,'' said Trevor Taylor, 35, co-chief investment officer at Miami-based Innovative Options Management LLC. The firm's $90 million hedge fund rose 12.3 percent this year through August, after returning 25 percent in 2007.

Price swings that helped Taylor started with the collapse of subprime mortgages that have left the world's biggest banks with $506 billion of writedowns and credit losses in the past year, according to data compiled by Bloomberg. The Standard & Poor's 500 Index fell 19 percent since October as credit dried up and the U.S. economy edged to the brink of recession.

The S&P 500 fluctuated by more than 1 percent on 71 trading days this year, the most since 2003 and exceeding the 61-day annual average since 1928, said Howard Silverblatt, an analyst at S&P in New York. The index may have its most volatile year since 2002, when there were 125 swings of more than 1 percent.

There are about 50 volatility hedge funds globally managing a combined $9 billion, according to Newedge Group, owned by Paris-based Societe Generale SA and Credit Agricole SA. The funds seek to make money from buying and selling options contracts on securities and indexes. Traders usually purchase options when they expect market fluctuations to increase and sell the contracts when they expect it to fall.

Bear Stearns

Options give the right to buy or sell a security for a certain amount, the strike price, by a given date.

``We've been pleased with our investments,'' said Antonio Munoz, chief executive officer of New York-based EIM Management USA, a unit of EIM Group of Nyon, Switzerland, which invests $15 billion in hedge funds and has held volatility funds since 2002. ``They make money when others don't. They act like insurance in one's portfolio.''

U.S. stock swings, according to the most-watched gauge, the Chicago Board Options Exchange Volatility Index, rose to a five- year high of 32.24 on March 17, the day after the Federal Reserve rescued Bear Stearns Cos. It peaked at 45.74 in October 1998, when the collapse of Long-Term Capital Management LP destabilized financial markets worldwide.

Main Street

The index, known as the VIX, has averaged 23.12 this year, 33 percent higher than in 2007. The VIX, introduced in 1993, is calculated from prices paid for S&P 500 index options expiring in the next 30 days. It expresses expectations for the annualized percentage change in the S&P 500 and is considered a gauge of investor concern because it almost always rises when stocks fall.

``The story for the next year to 18 months is going to be problems moving from Wall Street to Main Street,'' said Thomas Felgner, 36, a portfolio manager at Morgan Stanley's FrontPoint Partners LLC, a $10 billion hedge-fund firm based in Greenwich, Connecticut. ``That's bad for people, but we don't think there's any way around it.''

The FrontPoint Volatility Opportunities Fund rose 7 percent this year through the end of August after returning 30 percent last year, according to investors. Felgner declined to comment on the fund or returns.

Analysts' Accuracy

Volatility has risen as analysts' accuracy in predicting U.S. profits fell to the lowest level in at least 16 years last quarter. Second-quarter earnings dropped 22 percent for the 470 companies in the S&P 500 that have released results so far, according to Bloomberg data. That's twice the drop that analysts projected during the first week of July.

``There's more uncertainty about corporate profits in the next few quarters and that in itself is a positive for macro volatility,'' said Abhinandan Deb, an equity-derivatives research analyst at Barclays Capital in London. ``If there are surprises to estimates, and we think that's more likely than not, that would boost volatility.''

The outcome of November's election in the U.S. and the resulting economic policy may heighten market turmoil, said Al Wilkinson, a former director of the Chicago Board Options Exchange who led the group that created the VIX index.

S&P Options

``We're going to be in an environment of elevated volatility for the next two years or so,'' said Wilkinson, 49, who runs Sydney-based Pengana Capital Ltd.'s Global Volatility Fund. ``It's going to get dicey.''

The Pengana fund has gained 21 percent this year as of August, according to investors. Wilkinson declined to comment on the returns.

The most common way to trade volatility is by using S&P 500 options, the most-active U.S. options family, with more than 12.4 million existing contracts.

An investor who believes stock-market volatility will decrease may sell options. An example would be selling a ``straddle,'' in which the trader creates and then sells a put below the current index level and a call above the index price. If the index stays between the strike price for each of the two options, the trader keeps the premium paid by the buyer. Call options give the right to buy and puts convey the right to sell.

`Tricky Asset Class'

``It's a tricky asset class,'' said Steve Gross, principal at New York-based Penso Capital Markets LLC, which advises clients on investments. ``Given the complexity of the strategy, it's hard for even the most knowledgeable investors to understand it.''

While analysts and traders expect volatility to remain above historic levels, the VIX has fallen 31 percent from its five-year high in March.

``Fed actions are muting the market, stopping it from the 3 percent moves or more that we saw in the past,'' said Russell Abrams, founder of New York-based $700 million hedge fund Titan Capital Group who previously co-led U.S. equity derivatives trading and convertible arbitrage at Merrill Lynch & Co.

Titan's main fund returned 7 percent this year through August after gaining 29 percent in 2007, according to an investor letter. Abrams declined to comment on his returns.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested.

Short Track Records

Managers of volatility funds have shorter track records, making it difficult to assess whether they generate consistent returns, said David Bailin, president of Bank of America Corp.'s Alternative Investment Solutions group in Stamford, Connecticut, which invests in hedge funds.

``Until managers have a proven, long-term, successful strategy, we're unlikely to invest,'' he said.

The VIX fell for four straight years through 2006 and slid to a 14-year low of 9.89 in January 2007, a month before the first reports of subprime losses. The index rose the most ever on Feb. 27, 2007, when it climbed 64 percent to 18.31, as the U.S. equity market had its worst rout in four years.

Shooter Fund Management LLP, a London-based hedge fund founded by options trader Mark Shooter, closed its multistrategy volatility fund last year because of money-losing stock index options trades. The Newedge Volatility Trading Index fell 5.4 percent when it started in 2003 and almost 0.5 percent the following year. It has returned about 16 percent since it was started in 2003, compared with the 57 percent gain of the S&P 500, including dividend reinvestments.

``You're either going to be buying at the bar tonight or crying,'' Silverblatt said. ``There's enormous opportunity if you're an options player because the volatility is there and if you hedge it right, you don't care if it's up or down. But if you don't do it properly, you can lose a lot of money.''

To contact the reporters on this story: Saijel Kishan in New York at skishan@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net.