Trends Watch: Investing in Volatility

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.   

This week, Elana talks with David Dredge, Chief Investment Officer, Convex Strategies Pte Ltd.  

What is your outlook for investing in volatility?  

First and foremost, it is important to understand that long volatility or tail risk strategies, much like insurance, should never be looked at on a stand-alone basis. The point of adding negatively correlating, highly asymmetric strategies to a portfolio is to improve the overall risk adjusted performance of the portfolio and to target superior geometrically compounded returns. While it is always a good idea to have greater convexity (accelerating correlation in good markets, decelerating correlation in bad markets) in your portfolio, we have been through a truly golden period over the last five years. With equity markets (a simple proxy of participating risk) realizing, in both up years and down years, returns diverging significantly away from historical averages, the benefits to compounding from improved convexity in portfolio construction have been exceptional when compared to risk comparable traditional investment structure (e.g., 60/40, risk parity, endowment model, etc). Given ongoing complexities in global financial and economic imbalances and ongoing attractiveness in volatility markets across many global markets, it does seem that this will continue to be the case. It’s just math.  

Where do you see the greatest opportunities and why?  

The opportunities will always vary with supply and demand in the various volatility markets around the globe. The main driver of supply is the pro-cyclical risk methodologies, and short-term perspectives, of virtually all market participants. Risk is, and has always been, leverage. There is plenty of leverage in the system, both explicit as well as implicit in the form of volatility selling. Fantastic opportunities for constructing efficient tail hedging strategies (we are adamant that it is a process, not a ‘trade’) exist across Asia, Europe and the U.S.; encompassing interest rates, FX, commodity, equity and credit markets. Pricing will tell you where efficient hedging opportunities exist, not forecasts of doom.  

What are the greatest challenges you face and why? 

Our greatest challenge is very clear: to find, maintain and grow cost efficient asymmetry. Everything in hedging strategies, think of it as investing in liabilities, is inverse to investing strategies, i.e., buying assets; most particularly, the relationship to time. Everyday, we need to fight the decaying sensitivity of our investments (all of which are fixed-term volatility derivative structures) and endeavour to push into ever growing duration and asymmetry in our portfolio. Finding and maintaining efficient asymmetry over years and decades of market cycles is an endless, unrelenting, task.  

What keeps you up at night? 

Of course, worries about our investors. Have we constructed sufficiently convex protection to allow them to withstand unforeseen market shocks? Will our structures pay off in a correlated systemic shock and provide the protection that our investors need? Have we been able to grow the potential asymmetry to at least somewhat keep up with the compounded gains they have accrued in the additional risk taking that we allowed for them? As more investors come to terms with the inadequacy of bonds as a portfolio risk mitigant and, as our investors have already done, move to explicit risk mitigation strategies, will the access and availability of efficiently priced convexity lessen? For now, there is still ample volatility supply, and we have been able to keep up with the continued extraordinary compounding on the risk-taking side of our investors, so we sleep pretty well at night.  

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.