Extreme Volatility Confounding Investors?
Duke Buchan III’s $1 billion hedge fund beat U.S. stocks by 46 percent in the decade through March, a period that included the steepest equity-market losses since the 1930s.
Then came the selloff in August when global stocks suffered their worst nine-day drop since the 2008 financial crisis. For four days, The Dow Jones Industrial Average (INDU) alternated between gains and losses of more than 400 points, the longest streak ever, and its intraday swings have averaged twice the level seen during the first seven months of the year. Last week, Buchan told clients he is shutting his firm Hunter Global Investors LP.
“Markets seem to be driven more by the latest news out of Europe than by a company’s earnings prospects,” Buchan, 48, said in a Dec. 8 investor letter. “We have not weathered the ensuing volatility well.”
Traders who used to profit from price swings are struggling as record stock market volatility shows no signs of abating. Hedge funds are on track to post their second-worst year on record, with managers such as John Paulson seeing bets undermined by Europe’s two-year sovereign-debt crisis and concerns over the U.S. economic recovery. U.S. mutual funds are headed for their weakest year in two decades, and the top Wall Street banks posted their worst quarter in trading and investment banking since the depths of the 2008 financial crisis.
Jeffrey Kronthal, a former Merrill Lynch & Co. senior fixed-income executive, said he’s never seen so much volatility over such a long period as this in his 33-year trading career.
‘Friend of Wall Street’
“Volatility, to a certain extent, was a friend of Wall Street, but not like this,” said Kronthal, who co-runs the $1.2 billion hedge fund KLS Diversified Asset Management in New York. “I haven’t seen volatility like this in a sustained way ever before.”
Traders used to profit from volatility in the aftermath of events such as the 2008 bankruptcy of investment bank Lehman Brothers Holdings Inc. (LEHMQ) or the 1998 collapse of U.S. hedge fund Long-Term Capital Management LP, when markets established or returned to medium- to long-term trends, according to Cedric Kohler, head of advisory at Fundana SA, a Geneva-based firm that advises clients on hedge-fund investing.
That hasn’t been the case in the second half of this year, as swings in the Chicago Board Options Exchange Volatility Index rose to a record. Three-month historic volatility (VIX) for the gauge known as the VIX increased to a record 191.59 on Oct. 31, above the 92.56 median over the past decade and surpassing the prior peak of 190.44 from December 2008. The benchmark for U.S. options prices and expected stock-market swings surged the most in four years on Aug. 8 after Standard & Poor’s stripped the U.S. of its top credit rating for the first time.
‘No Clear Trend’
The Dow plunged 634.76 points the first trading day after the U.S. downgrade for the biggest drop in two years. Over the next three days it rebounded 429.92 points, plunged 519.83 points and rallied 423.37 points.
Dow swings between intraday highs and lows averaged 126.49 points this year (SPX) through July. Since Aug. 1 they averaged 261.22 points. The Dow is 245.97 points above where it ended last year.
“We’re in an environment where no clear trend has emerged,” Kohler said.
Much of the volatility has been driven by Europe’s sovereign-debt crisis, which began more than two years ago in Greece before spreading to Ireland, Portugal, Italy and Spain. This month European leaders agreed to on a blueprint for a closer fiscal union, added 200 billion euros ($260 billion) to their warchest and sped the start of a 500 billion-euro rescue fund to next year. It didn’t put an end to the crisis.
The VIX closed at 26.04 yesterday, or 27 percent above the 20.56 average (BBHFUNDS) over its 21-year history. All VIX futures expiring next year trade above 30, indicating that investors are betting that stock-market volatility will remain above average for the next eight months. April futures trade at 31.70, which indicates that options traders expect the S&P 500 Index to make daily moves of about 2 percent.
John Brynjolfsson, who runs the $700 million hedge fund Armored Wolf LLC in Aliso Viejo, California, said he’s been skeptical about announcements by European policy makers to avert the crisis. He had made money for much of November before most of his gains for the month were wiped out as global stocks surged on Nov. 30 when six central banks made additional funds available to ease strains on markets.
‘It Was Frustrating’
“The risk-on, risk-off environment has been frustrating,” he said, adding that his firm has been trading portfolios more actively in the past months. “It was frustrating to lose the money we had made earlier in the month.”
Hedge funds overall declined an average 4.4 percent this year through November, according to Chicago-based Hedge Fund Research. The industry lost a record 19 percent in 2008. The S&P 500 returned 1.1 percent this year through November, including reinvested dividends.
The benchmark for American equities gained as much as 8.4 percent this year when it rose to the highest in almost three years. The intensifying debt crisis and U.S. downgrade pushed it to within 1 percentage point of a bear market, defined as a 20 percent plunge from its April high.
Hedge funds are also trailing U.S. Treasuries, considered the safest and most liquid investment. Treasuries returned 8.8 percent through November, according to Bank of America Merrill Lynch index data, despite the decision by S&P to downgrade the U.S.
‘Not Our Market’
“In the past, most periods of volatility were relatively brief, except during the 2000-2002 bear market where hedge funds were actually flat when the markets were down close to 50 percent,” said Mustafa Jama, chief investment officer at Morgan Stanley (MS) Alternative Investment Partners, which invests about $11.6 billion in hedge funds on behalf of clients. “What we’re seeing now is a sustained period of high volatility that’s proving very challenging for a lot of hedge-fund managers.”
S&P’s move destabilized equity markets at the beginning of August, and losses for the S&P 500 continued through early October as concern about the European crisis intensified. Hunter’s Buchan said the past four months in particular had been frustrating.
“It has not been our kind of market: macro-driven and highly correlated, with little regard to individual company fundamentals,” he said in the letter, referring to the fact that different securities have moved increasingly in lockstep.
JPMorgan Chase & Co., Bank of America Corp. (BAC), Citigroup Inc. (C), Goldman Sachs Group Inc. (GS) and Morgan Stanley posted $13.5 billion in trading revenue minus accounting gains for the third quarter, down 35 percent from a year earlier. Investment-banking revenue plunged 41 percent from the second quarter to $4.47 billion.
Back to 2008
Bank of America posted a roughly 90 percent drop in fixed- income trading revenue and Goldman Sachs had its lowest debt underwriting quarter since 2003. JPMorgan, the biggest U.S. lender by assets, doesn’t expect a pickup in investment bank revenue this quarter when excluding accounting adjustments, Chief Executive Officer Jamie Dimon said Dec. 7.
Compared with 2008, “the volatility in the markets is similar in terms of the fact that people are taking a much more conservative approach,” Brady Dougan, chief executive officer of Credit Suisse Group AG (CSGN), said in an interview last month. Switzerland’s second-largest bank on Nov. 1 said it would cut about 1,500 more jobs at the securities unit after the division reported its first quarterly loss since 2008.
In addition to record VIX volatility, traders are struggling because assets move increasingly in lockstep. The correlation of S&P 500 companies to gains or losses in the index increased to a record 0.86 last month, according to data compiled by Birinyi Associates Inc. in Westport, Connecticut. A level of 1 would mean all 500 stocks moved together. Correlation was 0.77 as of Nov. 18, 71 percent higher than its average since 1980, the data show.
“Past crises were more localized,” said Armored Wolf’s Brynjolfsson. “You had one company, or one market, industry or one country having problems and they often got bailed out. Here we’re dealing with an entire financial and economic system. It’s like walking on a high wire but this time without a safety net.”
Options investors are paying near-record prices to protect against a bear market in the next year on concern that Europe’s debt crisis in will spread. Implied volatility for puts that pay should the S&P 500 fall 20 percent over the next 12 months trade at 12.47 points above comparable calls, near last month’s record 13.69 point gap, according to data compiled by Bloomberg.
Managers in the $2 trillion hedge-fund industry are cutting risk. The average net exposure of equity market-neutral and long-short hedge funds fell to a two-year low of 0.67 at the end of November, according to data from JPMorgan.
Net exposure is calculated by subtracting the amount of a hedge fund’s bets on falling securities, or short positions, from its wagers on rising securities.
Paulson, who is having the worst year of his career as bets on a U.S. economic recovery go awry, reduced risk at his firm after losing as much as 47 percent in the first nine months in one of his biggest funds.
As a result he underperformed markets in October when the S&P 500 posted its best monthly gain since 1991 and his fund rose 2.4 percent. Paulson told investors last month that his New York-based firm, Paulson & Co., was reducing its bullish bets across all funds until there was more certainty that Europe can contain its debt crisis.
James Caird Asset Management LP, the London-based firm run by former Moore Capital Management LLC trader Tim Leslie, told clients this week that he plans to liquidate a $1.6 billion credit hedge fund after eight years because of losses this year.
Leslie attributed the losses to “poor liquidity and the unfolding crisis in financial markets.” He said the lack of market liquidity is “structural” and not something that will go away any time soon.
Smaller investors are also pulling back. U.S. mutual funds that invest in stocks and bonds attracted an estimated $42 billion through November, according to the Investment Company Institute, a Washington-based trade group. Funds have seen net withdrawals in every month since June, with redemptions reaching a peak in August.
At the current rate, 2011 is on pace to be the second- weakest year in two decades, ICI data show. In 2008, the worst year, investors withdrew $225 billion.
“Retail clients get particularly scared by excessive volatility,” Colm Kelleher, co-head of Morgan Stanley’s institutional securities unit, said at a Bloomberg conference on Dec. 1.
Market volatility may rise further as trading slows. U.S. equity-trading volume has averaged 7.90 billion shares a day this year, down from 8.52 billion shares per session last year and 9.77 billion shares in 2009, according to data compiled by Bloomberg.
Banks preparing for tougher capital standards under the Basel III international accord and complying with U.S. financial regulations that curb proprietary trading have reduced market liquidity, KLS’s Kronthal said. His fund has pared the amount of longer-term wagers it makes as a result.
“Traders like volatility to an extent but not when there’s this degree of uncertainty and lack of rhyme and reason behind it,” said Andy Nybo, principal at Tabb Group LLC in New York, a consulting firm to the financial-services industry. “I would say traders are suffering from volatility fatigue. It’s creating a reticence to trade.”
Indeed, traders like some volatility but not an insane amount of volatility. We are all suffering from a bad case of eurofatigue, no thanks to EU leaders and Germany's reluctance to bite the bullet and create a eurobond market.
Importantly, until we see a comprehensive resolution addressing this European debt crisis, one that includes a eurobond market, we are going to have to endure extreme volatility for a protracted period of time.
Who benefits from this extreme volatility? Mostly high frequency traders and a handful of elite hedge fund and asset managers, but also well governed defined benefit plans like HOOPP, performing quite well during these volatile times, bolstering the case for boosting DB pensions.
Having said this, as I stated in my previous comment on withering risk assets, I remain positioned for La Dolce Beta and think that money managers and asset allocators are not reading the macro environment properly. Pensions in particular should be capitalizing on this extreme volatility by taking opportunistic positions in risk assets. Unlike hedge funds and mutual funds, pensions have deep pockets and long time horizon to take opportunistic bets. Problem is most of them are too busy chasing after hedge funds or worrying about Europe, which is why they too are victims of extreme volatility.
Below, Tracey Flaherty, Senior Vice President at Natixis Global Associates, says volatility is here to stay and that alternative investments such as commodities, currencies and other strategies can mitigate downside risk. I agree but caution investors to rethink their notion of risk free assets, rethink their hedge funds strategy carefully and more importantly, rethink the way they manage their beta exposures by focusing more on taking intelligent opportunistic bets. And always pay attention to where the real smart money is going. Extreme volatility frustrates one group of investors but it presents extreme opportunities for another.