THE extreme stock swings after the US midterm elections have investors hedging against scenarios from an overdone response to the Democratic party’s sweep of Congress to a deeper and broader retreat in the artificial intelligence sector.
As the market steadies following last Thursday’s 4.4% plunge in the S&P 500, there’s room for funds and asset managers to employ more of the quant strategies on offer from banks. Prime brokers noted lower gross and net leverage heading into midterms. Furthermore, financing costs have been well off the summer peak, indicating an overall reduced demand for borrowing money to amp up positions.
Through October, global hedge fund gross leverage had fallen 8% since June, according to Morgan Stanley Prime Brokerage. And after Thursday, US hedge fund net leverage dropped to the bottom 10% since 2010.
As banks offer more and more sophisticated quant strategies, their hedge fund and institutional investor client conversations are increasingly centered on a common objective: crash protection with zero carry cost. Whether it’s improved trade timing through macro triggers or the latest volatility momentum signal using intraday data, a lot of Quantitative Investment Strategies (QIS) research continues to be poured into what some refer to as targeted convexity.
“A daily question I have right now is clients looking for a hedging strategy with the lowest cost of carry,” said Florian Peres, executive director at QIS data provider Premialab.
One way investors may limit the cost of hedges is through strategies that sell volatility. A perusal of QIS approaches shows systematic short volatility performing very well over the long term, with the carry from selling CBOE Volatility Index (VIX) call spreads doing best of all across providers. It even outperformed various dispersion tactics that have been popular with hedge funds over the past few years, according to Premialab data.
“We are seeing interest in combining vol carry with protection to help offset the cost of hedging,” said Adrien Geliot, Premialab’s chief executive officer. “VIX call spread carry is a good example – its historical performance reflects the premium embedded in VIX options, supported by demand for volatility protection and the pricing of vol-of-vol risk.”
The systematic nature of QIS, where complex trades once the province of hedge funds are packaged into swaps for a broader range of clients, means the success of a strategy relies more on when the trade is opened and closed. That makes having a reliable market timing signal especially important.
“Two different strategies can look similar in terms of their headline exposure, but performance can vary significantly,” said Geliot. “For example, with long 0DTE puts, the timing of the trade intraday makes a large difference to performance.”
Given the difficulty and complexity of market timing, some investors use external data providers, quants or asset managers that have researched a timing signal and run money in it successfully across multiple business cycles.
“One of the challenges with signal-based strategies is that their effectiveness can deteriorate out of sample,” said Richa Singh, head of cross asset volatility and equity QIS structuring at UBS Group AG.
“We partnered with an external asset manager, One River Switzerland, to access specialist expertise and IP around some of their long-volatility timing signals, live for more than 10 years with capital deployed behind it,” said Singh.
“That type of live experience is very difficult to replicate in-house, so this is one of the instances where it can make sense to partner with external specialists.”
Bank quants continue to develop ideas for zero-cost and even positive carry hedging often via defensive forms of volatility dispersion. After the July-August contraction of single-stock volatility that led to a drawdown in dispersion profit and loss, several of the systematic volatility dispersion baskets recovered during the earnings season.
Even during Thursday’s slide, JPMorgan Chase & Co’s US Technology Gamma Dispersion Index was up more than 6% over the past year.
“One of the popular themes within dispersion has been custom single-name baskets concentrated in tech-heavy names,” said Singh. “These implementations allow investors to maintain exposure to high-conviction names and themes through the cycle, while adding a degree of protection in the event of a correction.”
The next frontier for dispersion QIS may lie in developing a timing signal to dynamically manage the short index volatility leg.
When indexes are gyrating by 5% on seemingly little news, selling index volatility to fund long single-stock volatility becomes a daunting proposition.
In effect, strategies may evolve from conventional dispersion trades in calmer markets into outright long single-stock volatility positions during periods of market stress, dynamically adjusting their exposure as correlations rise.
It’s not just an outright crash that investors are worried about.
Many hedge funds are more interested in positioning for grind-lower scenarios, which goes a long way to explain the popularity of spot down/volatility down trades. — Bloomberg
Christian Dass is a writer for Bloomberg. The views expressed here are his own.