A few years ago volatility traders were niche players at big banks. Now they're moving to established hedge funds or setting up their own so-called vol funds. The pitch to prospective investors: Volatility should be considered an asset class in itself, like stocks, bonds, or commodities.
Hedge funds, of which volatility funds are a subset, are famous for jumping in and out of markets quickly and aggressively. Most make specialized bets on everything from merger activity to convertible bonds without regard to the overall market's direction. Volatility funds bet purely on swings in volatility. And they live for weeks like June 8-15, when the Standard & Poor's 500-stock index fell nearly 3% in three trading sessions, then gained most of it back in the next two.
Because hedge funds are so secretive, it's hard to count up all the vol funds out there. Fimat, the global brokerage unit of Soci?t? G?n?rale Group (SCGLY
), tracks 10 of them, aggregating their results into a monthly performance measure called the Fimat Volatility Arbitrage Median. Some 1,800 investors and fund managers subscribe to it, up from 400 when it launched in 2003. The burgeoning market might already be worth $10 billion, say executives at Fimat.
"We're in a period of unusual eco-political uncertainty," says Philip Gotthelf, a longtime metals trader who manages $62 million at Equidex Inc. in Closter, N.J. "The opportunities to profit from volatility have increased." Gotthelf says the accounts he manages have posted 25% to 75% annualized returns in 2006.
In truly tumultuous times, vol traders thrive. The Turtle Fund, one of a group of funds managing $300 million on Britain's Isle of Man, posted a 20.75% gain in 2002, while the S&P 500 thrashed around, finishing the year down 23%. Conversely, serene markets are bad for vol traders. Turtle's returns shrank to between 1.65% and 5.5% a year from 2003 to 2005 as volatility fell to multiyear lows. But through June of this year it has returned 5.78% -- with 1.84% of that in the erratic month of June. The Volatility Arbitrage Median was up 3.41% year to date through June, nearly twice the S&P 500's return of 1.76%.
Vol traders deal mostly in options on stock indexes and the Chicago Board Options Exchange's Volatility Index, known as the VIX or the "fear index," which tallies option prices to gauge expectations of near-term volatility. The VIX climbed sharply in recent months. But while the jump felt dramatic, it was fairly modest compared with the trauma of 2000-03. Turtle Fund director Marco De Franceschini expects markets to get choppier from here. Among other things, he says, Japan is likely to hike interest rates soon, which may stir the markets as much as the Fed's nonstop hikes have.
Even small traders are getting interested in volatility. John F. Carter, an Austin (Tex.) trader and president of financial analysis firm Trade The Markets, has one account dedicated solely to vol trading. He says he has increased it from $50,000 to $86,000 year to date. The May-June flurry was a refreshing turn of events, he says. For much of the last couple of years, investing was "like watching paint dry."
Retail brokerages, meanwhile, report a brisk business in VIX options, launched by the CBOE in February. "We're seeing a lot of activity," says Randy Frederick, director of derivatives at Charles Schwab & Co. (SCHW
) That's probably a bad thing. VIX options are highly risky and best left to serious professionals with fancy computer models, say financial advisers. Then again, some investors who have watched their mutual funds gyrate wildly in recent months might think that doing nothing is the riskiest strategy of all. By Joseph Weber