Stockholm (HedgeNordic) – Elevated macroeconomic or geopolitical uncertainty bringing bouts of extreme market turbulence have frequently plagued financial markets. And arguably, the most frequent, painful and costly mistakes in investing are made during periods of high volatility. Some may even consider volatility an investor’s biggest enemy. There are strategies, however, that bloom in such environments and rely on volatility as their main source of life.
Danske Bank Asset Management’s Quant and Overlay team, part of the Solutions and Alternatives investment organization that also houses Danske Bank’s fixed-income hedge fund team, has designed an investment strategy that generates returns “by understanding the fundamental and structural drivers of market volatility” across asset classes. “This is a multi-asset, multi-strategy fund that applies different strategies, all within the volatility space or with a connection to the volatility space,” explains Jacob Øland Jensen, the strategy’s Chief Portfolio Manager. “With Alternative Investments being one of our strategic focus areas, we are happy to have expanded a very successful range of hedge funds with this multi-asset approach.”
“This is a multi-asset, multi-strategy fund that applies different strategies, all within the volatility space or with a connection to the volatility space.”
While most traditional volatility-focused managers predominantly harvest the “volatility risk premium,” which results from implied volatility overstating the subsequent realized volatility in options, the Danske Bank Quant and Overlay team focus on capturing returns from multiple sources in the volatility space. “We don’t usually say that we focus on harvesting volatility risk premia, as this term encompasses a very narrow definition and we do way more than that,” says Øland. “The pure volatility risk premium is the source of return that most investors are aware of and perhaps even most exposed to, but for us, it is only a small part of the risk in the portfolio.”
“We don’t usually say that we focus on harvesting volatility risk premia, as this term encompasses a very narrow definition and we do way more than that.”
“The traditional volatility risk premium stems from the fact that market participants pay more for option protection than the protection is worth, just like insurance,” explains Øland. The volatility risk premium, in essence, is a form of financial insurance. “This is a risk premium that is as close to fundamental in nature as you can probably get,” he argues. “Risk averseness is ingrained in human DNA and it is well documented that the average investor is willing to pay an excess premium for this financial insurance.” Managers often systematically sell combinations of calls and puts or build straddles and strangles to effectively and consistently capture volatility risk premia and other structural imbalances.
Although the volatility risk premium represents a rich and persistent source of returns for investors, the team behind Danske Invest Global Cross Asset Volatility has opted to design a broader portfolio to harvest volatility-driven sources of returns. “The richest risk premium in the volatility space is the traditional volatility risk premium. No doubt about that,” argues Øland. “This risk premium is very persistent. We do not expect that people will stop paying a premium for insurance,” he continues. The reason for building a well-diversified set of strategies that go beyond harvesting traditional volatility risk premia is because “capturing this premium is a bit of a timing game.” Additionally, “the diversification within the fund is very much a design feature,” says Øland.
Not Playing the Timing Game
Both long- and short-volatility strategies are subject to the “timing game.” Short volatility strategies, for instance, can generate steady returns by earning capped premiums in return for selling options – thereby earning steady returns until a big move in the underlying’s price can lead to large, and potentially unlimited, losses. Furthermore, such drawdowns will often occur at the same time as risky assets underperform. Meanwhile, long-volatility strategies, which have a positively asymmetric payoff profile with the downside limited to the cost of buying options coupled with unlimited upside, can generate outsized profits when large movements in the underlying do happen. These long-volatility strategies, however, can “bleed to death” after prolonged periods of subdued volatility.
“We use a multi-strategy approach by tapping into various return sources in the volatility space to generate more time-independent returns.”
“We use a multi-strategy approach by tapping into various return sources in the volatility space to generate more time-independent returns,” argues Øland. Danske Invest Global Cross Asset Volatility has been deploying eight systematic strategies, only one of which focuses on capturing traditional volatility risk premia, to monetize on multiple drivers of volatility. These systematic and repeatable strategies seek to harvest sources of returns stemming from the convexity embedded in volatility, structural imbalances within different asset classes or regional markets, as well as volatility price differences across and within asset classes.
To design the strategies, the Danske Bank Quant and Overlay team forms testable economic hypotheses, for example, on whether market participants are willing to pay a premium for buying protection in various asset classes via options. “To test an economic hypothesis, we subject it to numerous years of data to test whether we see this hypothesis playing out in the real world,” explains Øland. “If the hypothesis turns out to be validated by the data, we define a rulebook for implementing a systematic strategy.”
“We see real value coming from the cross-asset approach.”
Each of these systematic strategies focuses on a specific source of volatility-stemming alpha across several asset classes that include equities, interest rates and currencies. “We see real value coming from the cross-asset approach,” emphasizes Øland. “Instead of just being in a single asset class, we seek to find these types of fundamental, structural, or relative value opportunities in several asset classes,” he continues. “We exploit the structural imbalances that are most attractive to find the best fit and most attractively-priced volatility trades for the portfolio.”
Embedded Downside Protection
By design, Danske Invest Global Cross Asset Volatility thrives either in a low- or high-volatility environment, less so during transition periods from low volatility to high volatility or vice versa. “Looking from a very top-down level, many of our systematic strategies perform in a low volatility environment or in extremely high volatility markets,” explains Øland. “In a volatility regime shift between high and low volatility or vice versa, that is where you could expect headwinds for some of our strategies.”
A number of the strategies are defensive in nature or have built-in risk-mitigating features – such as signals, negative beta or positive convexity, enabling Danske Invest Global Cross Asset Volatility to hold up very well in periods of increased volatility such as February this year, or March of 2020. According to Øland, their fund’s risk-mitigation properties are achieved through three main venues. “First, we have systematic strategies that are defensive in nature that can deliver a positive return if equities sell-off. That is the purest protection with negative correlation to equities.”
“We have systematic strategies that are defensive in nature that can deliver a positive return if equities sell-off. Second, we have systematic strategies that have risk-mitigating features embedded…”
“Second, we have systematic strategies that have risk-mitigating features embedded, for instance, signal-based volatility strategies that usually sell volatility but switch to buying volatility if some conditions are met,” says Øland. “These signals usually kick in when markets are in turmoil.” Third, the team has the ability to deploy tactical strategies for buying tail protection on a discretionary basis when necessary. “The tactical mandate is more opportunistic in nature and involves looking at the current market pricing of options and volatility instruments in general,” explains Øland.
“All systematic strategies have embedded risk, so we use the tactical mandate to adjust that risk, so that the full portfolio is aligned to our market views.”
“All systematic strategies have embedded risk, so we use the tactical mandate to adjust that risk, so that the full portfolio is aligned to our market views,” elaborates Øland. “We are willing to pay for such protection through our tactical mandate. We didn’t design the tactical overlay to necessarily deliver the same risk-adjusted returns as the systematic strategies,” according to the strategy’s chief portfolio manager. “We don’t see the tactical strategies as a stand-alone portfolio, rather as the ideal complement to our systematic strategies to make the fund even more attractive.” The deployment of tactical strategies is a key feature of the investment strategy employed by Danske Invest Global Cross Asset Volatility. “We also use the tactical portfolio to generate returns, especially in periods where the systematic strategies look less attractive.”
Place in a Portfolio
Danske Invest Global Cross Asset Volatility specifically aims at exhibiting low correlation to risky assets, primarily in stressed markets, and at delivering between four to six percent after fees at an annualized volatility of about ten percent. The fund has performed as intended with a three-year track record of 5.2 percent annualised net excess return, a return/volatility ratio of 0.7 and a clear demonstration of providing diversification to traditional risky assets. “We see this fund as a replacement for something like the high yield exposure in a broader portfolio, not for the most aggressive or most risky parts of the portfolio,” says Øland. “We believe investors should see the fund as an attractive component of a portfolio, bringing strong standalone risk-adjusted returns while being a better diversifier than many single asset class or macro hedge funds or traditional assets of a similar risk level. For exactly these reasons, our institutional investors as well as our internally managed flagship portfolio solutions invest in the Global Cross Asset Volatility fund and have enjoyed the strong risk-adjusted returns.”
“The fund is very much designed to be a portfolio component with low correlation to risky assets, especially in stress conditions, while also delivering good risk reward on its own.”
“The fund is very much designed to be a portfolio component with low correlation to risky assets, especially in stress conditions, while also delivering good risk reward on its own,” according to Øland. For investors not interested in the wild cards that market volatility often deals, the strategy employed by Danske Invest Global Cross Asset Volatility can be a very valuable addition to their portfolios.
This article features in HedgeNordic’s “Nordic Hedge Fund Industry Report.”