Volatility - The Good, the Bad, and the Ugly By Rob Brown, PhD, CFA I. Introduction The 1966 Italian epic spaghetti western “The Good, the Bad and the Ugly,” starred Clint Eastwood as “Blondie” (The Good), Lee Van Cleef as “Angel Eyes” (The Bad), and Eli Wallach as “Tuco” (The Ugly)1. I draw the analogy between this piece of Americana and a discussion of volatility because in both cases there is a highly nuanced storyline and the characters play ambiguous, overlapping, but nevertheless distinct roles – for better, worse, or terrible. Volatility has been one of the most prominent topics among institutional investors and their investment managers since the advent of The Great Dislocation2. This dialogue was recently reenergized by volatility’s several-fold increase resulting from the global contagion3 emanating out of Europe. As Greece found itself unable to refinance its government debt and the market vigilantes questioned the viability or relative attractiveness of the Euro currency, the VIX soared from 15.6 in April to 45.8 in May. It is generally said that hedge funds, on average, are exposed to “short volatility.” The meaning of this statement is that if volatility were to spike upward by enough within a sufficiently short time period, hedge funds would deliver negative returns – potentially severely negative returns. How could hedge funds convey “short volatility?” In effect, this would mean that hedge funds were selling insurance against rare and isolated extreme negative events. Recall that sellers of insurance must pay out claims when catastrophe strikes, i.e., they experience losses. Now, I don’t mean that hedge funds are literally or directly selling insurance – only in the most indirect and fuzzy sense. But the analogy holds and it holds quite strongly. 1“The Good, the Bad and the Ugly” is a 1966 Italian epic spaghetti western film directed by Sergio Leone, starring Clint Eastwood, Lee Van Cleef, and Eli Wallach. The movie was first released in Italian (Il buono, il brutto, il cattivo) in Italy in 1966 and later in English in the U.S. in 1967. 2 “The Great Dislocation” refers to the global economic decline and associated financial markets upheaval that felt its first initial tremors in 2007, its major collapse in 2008, and continues through today. 3 The recent global contagion was first initiated on April 23, 2010. During the 14 day period spanning April 23, 2010 through May 7, 2010, inclusive, the Russell 2000 returned -18.835%, High Yield CDX returned -5.979%, and Investment Grade CDX earned -1.802%. The VIX closed at 15.58 on April 12, 2010 and at 45.79 on May 20, 2010. II. You are exposed to volatility Let’s step back for a moment and remind ourselves of what hedge funds are. They are a direct alternative to traditional vanilla long-only managers. Hedge funds exist because they provide a more distilled, concentrated and more efficiently structured mechanism for obtaining exposure to active management bets (alpha, out-performance relative to some predetermined benchmark). But, unfortunately, they also carry, embedded within themselves, exposure to something else. Hedge funds also expose the investor to certain factor exposures (e.g., interest rates, credit spreads, commodities, or equity risk premia)4. One of the factors that almost all hedge funds are exposed to is volatility. Some factor exposures are easier to understand and evaluate than others. Domestic interest rates are reasonably well defined by the U.S. Treasury bond term structure and by the parallel interest rate term structures within the derivatives markets. Unfortunately, volatility is one of the most difficult factors to identify, evaluate, or understand. Perhaps an analogy will help. Consider the difference between a broken bone and cancer. A broken bone is simple, straightforward and is cured with well-defined and well-understood remedies. In contrast, cancer spans a vast array of only vaguely related maladies whose causality (much less treatment) is poorly understood. Interest rates are like the broken bone, volatility is like cancer. We have a tendency to speak of volatility as if it were one thing, behaving in a well- defined sense. But it is not one phenomenon, but many behaviors that are only loosely related, poorly understood, and only partially treatable – some of which, as seen below, may actually be beneficial in a perverse way (think of Clint Eastwood in The Good, the Bad and the Ugly). Nevertheless, we can appreciate some of volatility’s most obvious characteristics. Recall my earlier reference to how exhibiting short volatility is potentially analogous to selling insurance. Carry this analogy a bit further. The insurance industry has always experienced three distinctly different levels of profitability: 1. They experience quite attractive profitability during normal periods (the vast majority of the time). The Good. 2. They experience unappealing, disappointing profitability during extended periods of quiescence (something that happens only occasionally) as a result of increased, and sometimes unbridled competition. The Bad. 3. And, they experience terrible losses when disaster strikes on a major scale (this is a rare event). The Ugly. 4 Hedge funds are not a separate or distinct asset class. They do not bring a unique or differentiated factor exposure to the investor. Nothing about them in anyway suggests that they have any basis for being identified as a separate asset class. Historically, hedge funds have exhibited three identical phases – the good, the bad, and the ugly. The following exhibit identifies the three faces of volatility.5 The three faces of volatility GOOD BAD UGLY 82.2% of the time 9.0% of the time 8.8% of the time Normal times of not too much and not too Long quiescent periods of exceptional Extreme and exceptional idiosyncratic little volatility quiet and serenity volatility Highly attractive hedge fund returns Poor unattractive hedge fund returns Painful hedge fund returns Statistics based on hedge fund returns spanning the time period 02.01.1977 through 04.30.2010 III. Volatility’s impact on hedge fund returns To make this discussion a bit more specific, we need to examine the data. This will require adopting a specific definition of volatility. Again, let me remind the reader of the dangers inherent in such a definition: it approximates the gross oversimplification entailed when one intends to discuss the overarching behaviors of and treatments for cancer, but focuses on only a single type, e.g., melanoma. Nevertheless, for this discussion, I restrict myself to the volatility of S&P 500 daily returns.6 The following graphic shows how S&P 500 volatility has changed over the last 33+ years. 5 Hedge fund returns are based on the HFRI Fund Weighted Composite Index provided by Hedge Fund Research Inc. This is an equal-weighted index of individual hedge funds and is the most comprehensive index that HFRI provides. It was last updated on May 17, 2010, and covers the time period from 01.01.1990 through 04.30.2010. For the time period spanning 02.01.1977 through 12.31.1989, hedge fund returns were provided by the HFN Hedge Fund Aggregate Index provided by HFN HedgeFund.net. This is an equal-weighted index of individual hedge funds and is the most comprehensive index that HFN provides. It was last updated on May 22, 2010, and as of that date reflected the returns of 4,889 individual hedge funds. 6 Characteristically, alpha (out-performance) is not so much affected by the absolute level of volatility, but instead tends to be more powerfully driven by changes in the level of volatility. For this reason we use the proportionate percentage change in daily volatility for the current month relative to its average level over the two prior months. In all cases the daily returns of the S&P 500 Index were used to make these calculations. As a result, the measure of volatility that was used throughout this article was more specifically defined by: “The percentage change in the annualized standard deviation of daily returns over the current month relative (in a proportionate percentage) to the average of the annualized standard deviation of daily returns over the two prior months.” Measure of monthly volatility over the last 33+ years Oct ‘87 Black Monday. Financial panic of 1987 413 Oct ‘00 USS Cole Yemen bombing. Argentine economic crisis. Energy price crisis Jan ‘00 335 Oct ‘89 Y2K crisis. Dot‐com mania accelerates. n) Non‐proliferation treaty crisis o i Savings and loan t a i crisis. Keating five v de d r 257 Aug ‘98 Sep & Oct ‘08 US embassy bombings nda Lehman Brothers collapses. a t Aug ‘82 Africa. Russian financial The “Great Dislocation” s Latin American debt crisis. Russia defaults in e crisis. Mexico’s ng 178 liquidity crisis ha c ( Aug ‘90 y Iraqi invasion of ilit t Kuwait. Persian a l o Gulf crisis v 100 of e ur s a Me 22 ‐57 Feb Apr 1977 2010 When this measure of domestic stock market volatility is compared to the performance of the hedge fund universe7 since February 1977, volatility explains 11% of hedge fund returns – that’s a pretty big portion8, providing us with a strong indication as to volatility’s critical importance. We can obtain a better understanding of the negative contribution resulting from volatility if we strip out its effect from historic hedge fund returns. The following exhibit9 shows the probability 7 The hedge fund returns are based on the HFRI Fund Weighted Composite Index provided by Hedge Fund Research Inc. This is an equal-weighted index of individual hedge funds and is the most comprehensive index that HFRI provides. It was last updated on May 17, 2010, and covers the time period from 01.01.1990 through 04.30.2010.