Portfolio managers for specialist hedge fund strategies use their knowledge of a particular market to pursue niche investment opportunities.
Once an esoteric pursuit, volatility trading has evolved over recent years to become a recognized investable asset.
Volatility trading hedge fund managers will trade volatility-related assets globally, across countries and across asset classes, in order to exploit perceived differences in volatility pricing. The overall goal is to purchase underpriced volatility and sell overpriced volatility.
In the U.S. markets, the most common volatility futures are contracts on the VIX index, which tracks the 30-day implied volatility of the S&P 500 index. VIX contracts tend to be mean reverting because high volatility naturally tends to dissipate over time.
- Long volatility positioning exhibits positive convexity, which can be particularly useful for hedging purposes. On the short side, option premium sellers generally extract steadier returns in normal market environments.
- Relative value volatility trading may be a useful source of portfolio return alpha across different geographies and asset classes.
- Liquidity varies across the different instruments used for implementation. VIX Index futures and options are very liquid; exchange-traded index options are generally liquid, but with the longest tenors of about two years (with liquidity decreasing as tenor increases); OTC contracts can be customized with longer maturities but are less liquid and less fungible between different counterparties.
- The natural convexity of volatility instruments typically means that outsized gains may be earned at times with very little up-front risk. Although notional values appear nominally levered, the asymmetric nature of long optionality is an attractive aspect of this strategy.
In recent years, numerous hedge funds have formed to take advantage of attractive investment opportunities related to insurance policies. In a typical life settlement transaction, an insured person will sell (generally through a broker) their insurance policy to a hedge fund. After the investor pays the insured for the policy, the hedge fund then will be liable for the premium payments and will also receive the death benefit upon the passing of the insured.
Catastrophe risk reinsurance is another area where hedge funds are increasingly investing. Catastrophe insurance covers the holder against earthquakes, tornadoes, hurricanes, floods, and the like. In order to diversify and decrease risk, insurance companies in their normal course of business will sell off some of their risk to reinsurance companies, who may then lay these risks off on hedge funds in exchange for capital.