Prior to the beginning of 2022, the New York-based volatility arbitrage fund The Ambrus Group postulated a change in the market microstructure. In a video, the firm’s leadership said markets were fragile and traditional portfolio constructions such as 60/40 were suboptimal.
“It’s a bit scary to think that there are people that manage hundreds of millions using dogmatic approaches when it comes to protecting a portfolio from a disaster,” co-chief investment officer Kris Sidial said in the video. Using derivatives, colloquially referred to as volatility, investors could “potentially outperform the market” and limit losses.
After last speaking with Ambrus in mid-2021, Benzinga checked in with Sidial this month to reflect on his market perspectives, as well as discuss opportunities and threats in 2023.
Swapping 60/40 For Volatility Worked
If you’re new to the game, 60/40 is a portfolio construction wherein 60% of the holdings are in stocks and 40% of the holdings are in bonds. The mix is supposed to perform well in most volatile markets, history would suggest.
However, 60/40 endured one of its worst stretches last year. Despite this, Ambrus managed to end positively using volatility, an area of the markets it is committed to educating investors about via its publicly available research.
“That does not mean all volatility funds ended the same way,” Sidial said in a nod to his team’s unique method of leveraging options’ multidimensionality. To note, Ambrus’ methods are limiting, though. By adding to its assets under management, the firm can run the risk of eating away its own alpha or ability to outperform.
“Therefore, we want to stay as a smaller- to medium-sized firm,” Sidial explained, adding that at Ambrus “quality matters more than quantity,” and it’s better to run “just a few top-notch funds in terms of pure alpha, rather than scaling too far and potentially underperforming.”
Volatility Could Outperform In 2023
As noted, 2022 was a difficult year for some equity volatility funds competing with Ambrus.
“It was a surprise that [owning] volatility underperformed broadly speaking. A high spot-vol beta had us thinking volatility was coming to life. We thought there would be more follow-through.”
In short, volatility’s sensitivity to underlying prices was low, and Sidial cast blame, in part, on commodity trading advisors and strong volatility supply.
“One of the reasons was the attraction to CTAs” who hedged against inflation and rising rates with commodity exposure. “Second, traders looked at 2022 as an opportunity to sell volatility. The consensus trade that a slow grind down would be the case was right.”
Basically, investors expected the market to fall. Some sold their equities and bought volatility, proactively. When the decline happened, investors opted to monetize and sell volatility. A heightened Cboe Volatility Index or VIX, as well as inflated measures like the put-to-call ratio, likely the result of stock loan desks replacing their short stock with deep-in-the-money puts due to higher interest rates, masked the pressure options prices were under.
Though volatility prices can move towards the extremes, clustering and mean-reverting, current trends may eventually become exhausted. Naive measures like the VVIX, which is the volatility of the VIX or the volatility of the S&P 500’s volatility, are printing at levels last seen in 2017.
This would suggest “we can get cheap exposure to convexity while a lot of people are worried.”
“Even if inflation continues, the rate at which it rises won’t be the same. Due to this, CTA exposures likely will not perform as well as they did in 2022, and that’s why you may see more opportunities in the volatility space.”
The Major Risks To Markets In 2023
Exchanges are enabling traders to express their opinions across more options that expire over shorter- and longer-time horizons. Options trading in certain cash-settled products is available nearly 24 hours now, as well.
On the other side of the growing S&P 500 and VIX complexes is a small, concentrated group of market makers taking on far more exposure to risk. This and the private market investors’ liquidity issues are concerns that may lead to volatility outperforming.
“During moments of market stress, the market makers are unable to keep up with the demands of frenetic investors. If you think of GameStop Corp GME, which we discussed before, there was this reflexive dynamic that happened when investors rushed into the stock one way.”
“That same dynamic can happen on the way down.” Market makers will mark up options prices during stressful events which can pressure markets; as the price of options rises, option deltas, or their exposure to direction, rise, and this prompts bearish vanna hedging flows as they are called, Sidial said.
Additionally, private market investors raising cash to meet capital calls may prompt sales of the more liquid public markets. “There are large pension plans in the U.S., and their mark-to-market or mark-to-model private deals are getting marked down. To source liquidity, they may have to sell some of their holdings in the public equity markets.”
A Tip From An Expert Volatility Trader
At the end of the day, markets are dynamic and you have to take what they give you. Not having a process and “crab investing” may result in investors missing out on opportunities.
Therefore, “having an outlook and process to express that outlook,” like Ambrus, which doesn’t “put trades on a whim or take macro bets,” is optimal. “It’s not as easy as saying: ‘Buy volatility because it’s cheap or sell it because it is expensive.’”
As a validation, Sidial pointed to 2017, when volatility was at some of its lowest levels. Back then, the correct trade was to sell volatility, “because volatility can be bimodal.” Therefore, if you sold volatility, you made money due to its clustering.
“If you’re trading volatility, let there be an underlying catalyst for doing so,” he suggested.