Volatility Hedge Funds: The Good, The Bad, And The Ugly

In finance 101, there is usually little doubt on what constitutes the major asset classes in the investment industry, i.e. there are the traditional ones like equities or fixed income as well as alternatives like real estate or private equity.

The instruments of each of these asset classes have unique characteristics. Stocks have unlimited upside while bonds have limited upside, but both are typically regulated securities. In contrast, private equity and real estate are mostly unregulated, private investments. Seems like clearly differentiated asset types.

However, we can change the perspective and make the case that all of these are the same. None will do particularly well when the economy is heading into a recession. Equity, whether held publicly or privately, and bonds of corporates, as well as buildings, will decline in value. These assets provide the same exposure to the economic factor and could therefore be considered as diverse components of essentially the same asset class.

How about hedge funds? Some have labeled these as a distinct asset class, others as structures of getting exposure to existing asset classes. The New York Times called them compensation structures for the ones who operate them. It gets even more challenging with volatility, which is traded and represents a derivative of equities. There is unlikely a definite answer.

However, volatility is interesting, as it is broadly negatively correlated to economic growth. When the economy is growing, then economic and financial volatility tends to decline. And vice versa; when the economy is declining, volatility tends to increase.

Given this, volatility strategies might be attractive for diversification, even if it might not be an asset class on its own. In this short research note, we explore volatility strategies offered by hedge funds.

PERFORMANCE OF VOLATILITY HEDGE FUNDS

We are using four indices representing volatility hedge funds. The HFRX Volatility index includes funds that are long, neutral, and short volatility, while the other three are from Eurekahedge, which classifies funds into the different sub-strategies.

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