Hedge Funds Bet on Volatility


(The Wall Street Journal) -- Hedge funds are betting that the recent turbulence in U.S. stocks will persist—a reversal after wagering for more than two years that the equity market will remain calm.

Leveraged funds, a category that includes hedge funds, were net bullish on Cboe Volatility Index, or VIX, futures as of March 6, the latest Commodity Futures Trading Commission data show—marking the first time bullish wagers have outnumbered bearish ones on the contracts since February 2016.

The about-face by hedge funds and speculators comes after a rocky month for stocks, with the S&P 500 and Dow Jones Industrial Average entering correction territory in February as investors grew jittery about higher inflation and volatility bets gone wrong rippled through markets. Since then, market turmoil has receded, but one measure of stock volatility indicates that it remains above last year’s average level.

A bullish bet on VIX futures can be a bearish bet on stocks, because the two tend to move in opposite directions. Traders can tap the derivatives to make directional bets on volatility itself or use the contracts to hedge their portfolios.

Hedge funds aren’t always good at timing their volatility bets. Volatility hedge funds may have squandered a chance to shine last month. They posted lackluster returns despite a surge in market turbulence in February,  according to a March 9 report from JPMorgan Chase & Co. That environment should give volatility hedge funds more opportunities to make bets on which way volatility will trend and capture profits.

Short volatility hedge funds, which bet against volatility, didn't perform well last month as market swings picked up, which is to be expected, but long volatility strategies also floundered, according to JPMorgan, which analyzed data from Eurekahedge.

Strategies used by volatility hedge funds vary. Some bet on volatility through VIX futures and options or through derivatives on single stocks and indexes. Others try to foresee and profit from the next crash in financial markets. Volatility strategies are supposed to be less correlated to other assets in a portfolio.

JPMorgan estimates about $60 billion sits in volatility hedge funds, with most managing pension fund money.

Some fund managers were likely caught off guard by the volatility spike, which came after one of the most placid years in history. A Eurekahedge short volatility index, which tracks how the funds are doing, fell 3.9% in February, according to an estimate on the firm’s website.

This suggests that these short volatility hedge funds were poorly prepared or protected for a reversal of the past year’s low volatility trend,” wrote the JPMorgan analysts.

A Eurekahedge long volatility hedge fund index ticked up 0.35% in February, according to Eurekahedge’s website. But it barely reversed prior month’s losses when markets were calm, wrote the firm’s analysts.

A tail risk index, designed to track funds that profit from a market event with an extremely low probability--like February’s correction-- fell about 3%. This year, the four categories tracked by Eurekahedge and JPMorgan have underperformed the S&P 500’s 4% advance.


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