If you reward greed then why act surprised when it shows up ?

Many people have been asking me about recent developments in the volatility business, tragic funds collapses and other things. I figured I would abandon my typical restraint for a minute and give you my two cents.

In a quarter of a century I’ve seen my share of anomalies in the volatility market, yet none is as persistent as this one:

•                    Fund overtly sells a form of tail (asymmetrical payoff)

•                    Fund is praised for returns above average while market is quiet

•                    Fund raises more assets

•                    One day fund blows up abysmally as what is mathematically supposed to happen does happen. Usually at the peak of AUM

•                    As a consequence volatility industry as a whole is considered dangerous for months/years and suddenly many articles pop up about how dangerous the strategy is

This latest iteration is no exception. We had several funds lose close to 100%.

Of course, the fact this happens with volatility is no surprise. Volatility is mostly misunderstood by asset owners. Most still don’t make the distinction between vol arb, long vol, long tail, short tail. Many (and most multi strategy HFs too) bucket volatility in the quant category, together with extremely liquid strategies such as quantitative long/short equity and statistical arbitrage. While volatility does indeed use many quantitative methods, it differs from traditional “quant strategies” by a distant mile.

First, volatility is embedded in every investment strategy in every asset class. If you buy a stock you have a volatility exposure. If you buy a bond you do too. This alone makes it the mother of all asset classes.

Second, volatility is....well volatile !

You can’t bucket it with ultra liquid strategies that can be closed in the blink of an eye by pressing a button. There is convexity and mark to market. There are illiquid structured products. Would anyone bucket convert arb with quant strategies ?

Third, volatility is complex. There is no way around it. In addition there is often a knowledge imbalance between the managers and the allocators.

With such a bleak and complicated picture painted, why would anyone ever invest in volatility ? It clearly doesn’t seem like a winning proposition, especially if you’re not well versed in the subject.

For all these reasons, there are only 2 ways vol funds can actually exist. Either they do things “well” (more on that later) and only take assets from the very few savvy asset owners who understand it. Or they do extremely good marketing, checking all the right boxes: a couple of guys from a prestigious bank, strategy explained as insurance selling that performs extremely well in 99% of the cases (who isn’t tired of paying countless insurance premiums that all seem like a forced waste of money ?), prestigious investors who act as bellwethers.

Obviously, the latter method is the one making the news these days and in every single crisis before. It is also the surest way to get rich if you’re a volatility manager. It’s the only way to raise meaningful assets and have eye popping returns (and therefore fees) for a couple of years.

This system strongly encourages greed. And everybody complaining today is surely well aware of it. If I can run a scenario in 5 minutes to see that these books would lose billions in unfavorable market conditions then why can’t everyone do the same ? Even simpler, if you’re selling insurance, do you have the means of being a lender of last resort when things go sour ?

This begs the question: is there in fact room for volatility in investors’ portfolios ? Volatility exposure that is not going to wipe out the entire investment nor make the news negatively ? An exposure that won’t risk the job of the allocator pushing for it ?

I argue that there is.

Before delving into the specificities of the strategy, everything starts with the human factor: when investing into a strategy, any strategy, you invest in a manager, his skills, his personality, his vision. You have to trust that he will steer the ship soundly in all waters, trust him enough when he claims to deliver outsized returns in volatile markets to not redeem at an inopportune time.

There is value in trusting someone who tells you things as they are and does not sell you an unrealistic dream.

There is value in trusting someone who has actually traded a volatility book for years and been through various types of crisis in different regions.

There is value in trusting someone calm whose judgement will remain sound when things get tough.

There is value is trusting someone who isn’t simply selling you something but who understands there are real men and women’s savings at stake.

As for the strategy itself, proper due diligence can be achieved (either by savvy investors or consultants) and returns can answer many of the problematics some asset owners are currently facing. Like for other strategies, work needs to be done to understand the investing process,risk management and philosophy.

First, the variety and complexity of products can actually be an advantage of the strategy. It allows for more convex payoffs when you need them. It can offer diversification. But I use the word “can” because, like everything, it takes work to figure it out. Risk recycling, for example, can be toxic if done improperly, or it can be a steady source of revenue if you properly identify your role in the chain and your added value. It can also be a cheap source of convexity and protection.

Second, there are some imbalances in the market triggering opportunities. Some are persistent and others temporary. They can be the result of corporate activity, retail structured products, recurrent hedging patterns, rule based algorithms and more.

Third, volatility can be the answer to specific problems for investors, whether adding yield to an existing portfolio or protecting it. It can be a very cost efficient way to gain exposure to certain assets and payoffs.

I don’t want to get too technical here but the range of possibilities is endless and many problems can be solved very efficiently with volatility, specifically because it is embedded in every investment.

In conclusion, I hope I made it obvious that there’s no free lunch, and you get what you pay for (happy I could squeeze in the few sayings I know). While many are encouraged to embrace the path of least resistance unleashing the greed that will ultimately surely lead to their demise, there are a few of us out there who still take pride in doing things “well” for our investors and for ourselves. We realize we get hurt every time someone shines a bad light on the whole industry, but we also know we can still help and, unlike them we are still standing.