“A marathon, not a sprint”: Why patience is a virtue for volatility-focused hedge fund Dominicé
While volatility-focused hedge funds can often experience dramatic swings in performance, the long lean periods punctuated by sporadic surges in returns, Dominicé & Co Asset Management, a Geneva-based volatility-focused manager, has seen its long-running Cassiopeia fund flourish with consistency.
Dominicé, which was founded in 2004 by ex-Lombard Odier head of US and global equities Michel Dominicé, today manages some USD900 million in assets, its products spanning a range of investment strategies, including volatility, equities and real estate, as well as wealth management services.
The firm’s long-running equity volatility and derivatives-focused strategy, Cassiopeia, takes a defensive approach to markets, aiming to generate consistent positive returns throughout various cycles, uncorrelated to other assets.
Volatility-focused hedge funds can often toil for long periods, experiencing perennially unpredictable return streams, typically shining only during times of severe volatility shocks. During this year’s historic coronavirus-fuelled sell-off in Q1, a number of long-volatility and tail-risk hedge funds notched up stellar double-digit returns.
In contrast, Cassiopeia boasts an altogether more consistent track record within this sphere: the fund has recorded 14 positive years out of 16, generating sizeable returns during major crises and corrections. During the Global Financial Crisis, the strategy advanced 19 per cent annually amid the historic market rupture. More recently, during the dramatic volatility spike of February 2018, the fund remained up some 6 per cent.
A viable alternative
According to Pierre de Saab, partner and head of the firm’s investment team, the strategy’s success stems partly from its ability to source opportunities when there is more uncertainty in markets.
“It tends to generate larger returns for investors when the rest of their portfolio suffers,” says de Saab, who joined the firm in 2010 after spending ten years at UBS and Credit Suisse as a senior index derivatives trader. “This makes it a viable alternative to a long volatility or tail fund because it retains some of their characteristics but it does not bleed when markets are quiet.”
Cassiopeia approaches volatility as an asset, building a highly liquid portfolio of listed equity derivatives and equity volatility derivatives using a proprietary risk metric system. The aim is to remain firmly market-neutral, with zero correlation to equity markets, and maintain an average volatility level of between 5-10 per cent, which de Saab believes sets the strategy apart from other vol-focused funds.
“Our returns exhibit very low correlation not only to equities, but to major asset classes, hedge fund styles and investment factors, making it a valuable addition to almost any portfolio,” he continues. “This is especially remarkable, given we trade simple listed futures and options and do not engage into the more complex OTC structures.”
2020 has proved a strong year for Dominicé’s flagship fund, with returns reaching some 19 per cent since the start of the year.
Performance was driven by gains of more than 20 per cent amid March’s mayhem, and while the strategy slipped 1.3 per cent in April, it has since returned to positive territory in May.
“March has been, of course, the key month this year, and actually the key month of any year,” de Saab observes of this year’s unprecedented trading environment, noting how the fund constructed successful trades in both the S&P500 and Eurostoxx50 derivatives markets.
“On both markets, we generated profits by holding a long volatility position but also by switching to a short volatility position during the second half of that month.”
While markets have entered decidedly calmer territory in recent weeks, de Saab believes Cassiopeia remains well-placed to continue to capitalise on opportunities emerging out of the new investment environment.
With the economic fallout from the coronavirus pandemic likely to define markets for the foreseeable future, volatility markets are likely to remain inefficient, according to de Saab. Pointing to the historic levels of government stimulus poured into economies across developed markets, he maintains it is “not certain” that the economy will rebound to pre-crisis levels.
All of which ultimately means the prevailing environment will remain particularly supportive for volatility-based strategies in the coming months and years.
“On the macro side, the unprecedented level of monetary and fiscal stimulus is going to leave balance sheets of central banks overinflated and produce large deficits in state budgets,” he says. “This may actually cause another sovereign debt crisis in the near future, probably somewhere in the eurozone. The economic environment will remain fragile and therefore companies and investors will feel the need to maintain hedges.”
At the same time, recent events have pushed to extremes those risk measures – volatility, VaR, stress – that are commonly used by quantitative strategies and hedge funds to size their bets.
“As a result, they need to either scale back their investments or hold more protection,” he explains.
Despite this wealth of opportunities on the horizon, and a solid track record, de Saab nonetheless remains keenly aware of the assorted challenges faced by the firm.
“The challenge is always the same – to understand and interpret how the global macroeconomic environment impacts volatility markets,” he says.
“We are fortunate enough that we trade in very liquid instruments, which gives us the flexibility to turn around quickly the positions.
“Nevertheless, we are currently in volatile market environment where prices can move a lot. This is especially tricky when dealing with highly convex instruments like derivatives. We need to continue to adjust our investment and risk framework to a higher volatility regime, because capturing 1 volatility point with a 1mio vega position is not the same game when VIX is at 45 as when it sits at 15.”
Patience is a virtue
Casting his eye on the wider market, de Saab suggests this “tricky” trading landscape for the fund mirrors the prevailing investor appetite for strategies such as Dominicé’s, which at this point he says remains “mixed.”
“From our discussions with allocators, we gather that the largest chunk of the capital deployed recently has gone either to well-known large hedge funds that used to be closed and have just reopened, or to strategies that have suffered from a mark-down effect like credit,” he explains. “These are tactical plays, whereas we believe our product should be a strategic investment.”
Expanding on this point further, de Saab takes a longer-term perspective, suggesting that adopting a patient stance amid the still-unfolding uncertainty will ultimately help strengthen the firm’s investment pedigree further.
“We are not in a hurry,” he explains. “The conditions are going to remain supportive for the coming months and years. We need to take the necessary time to explain our case. This is a marathon, not a sprint.”
He adds: “We believe that the combination of real assets – equities; real estate - coupled with an uncorrelated alternative strategy like Cassiopeia is the winning combination in the context of zero interest capitalism.”