Optimal opportunities: Why current volatility levels are proving a “sweet spot” for alpha-focused funds

Volatility

Markets look set to remain in a “sweet spot” of heightened volatility – driven by Covid-19 uncertainty and the fallout from the US presidential election – offering a wealth of opportunities for alpha-focused strategies.

New research by JP Morgan Asset Management shows that current above-average volatility levels offer an “optimal environment” for certain alpha-based funds to capitalise on mispricings amid choppy trading and high dispersion, in contrast with more mixed prospects for equity and credit beta exposures.

The emerging investment landscape heading into 2021 offers a boon to a beleaguered hedge fund sector which in recent years has had to contend with patchy performances and continued investor aversion.

Prevailing volatility levels - between 15 and the early 30s on the VIX – are creating particularly strong trading opportunities for relative value, quantitative, and macro-based strategies, which can tap into the increased dispersion across markets, explained Karim Leguel, international head of investment specialists for hedge funds and alternative credit solutions at JP Morgan Asset Management.

“We see more dispersion coming up in terms of different stock dispersion and different stock behaviour, so that’s beneficial particularly for those strategies that trade short-to-medium dispersion between stocks,” Leguel told Hedgeweek.

While below-average volatility – measured at less than 15 on the VIX – offers fewer opportunities for alpha strategies to profit, as equity and credit beta positions thrives amid limited dispersion and tighter performance among assets, higher volatility regimes (greater than 32 on the VIX) are a poor environment for both alpha and beta positions, as sharper trends, reversals, and higher correlations can send investors fleeing, locking in losses.

In contrast, the prevailing midway point - or “sweet spot” – brings a welcome development for investors looking to add alpha and diversification to portfolios in light of elevated equity and core fixed income valuations, the research noted.

“The trend, in terms of what we see, is less about volatility being something that should spook the market, and more just about volatility coming back,” Leguel observed.

The increased macro and micro uncertainty means there is less focus among investors on hedge funds simply having a “one-way role”, as was the case during previous cycles.

Instead, Leguel said, the new regime offers hedge funds and other alternative strategies the chance to demonstrate both aspects of their role in portfolios: downside protection and upside participation.

“We also think the current environment is a really good environment for long/short funds, where there are winners and losers,” he added.

“The alpha component of long/short has really increased over the last 12 to 24 months compared to the previous period where the beta component was the driver and the alpha was not as significant.”