Volatility hedge fund Dominicé eyes inflation risk opportunities

Inflation

Investor caution over current inflation risks will see volatility remain at elevated levels, in turn offering rich investment opportunities for vol arbitrage trades, according to Dominicé & Co Asset Management, whose long-running flagship strategy continues to ride high this year.

Having scored a 13.3 per cent annual return last year, the Geneva-based firm’s equity volatility and derivatives-focused hedge fund Cassiopeia has advanced about 4.5 per cent so far this year, with successful calls across the S&P 500 and VIX complex driving this year’s returns.

Pierre de Saab, partner and head of asset management, says that while volatility levels have come off their peak lately, volatility remains in many cases quite expensive. This, in turn, is providing a positive setting for trading opportunities right now.

“An environment where volatility is either very expensive or very cheap is generally supportive for an arbitrage strategy like ours where we have the flexibility to buy and sell volatility,” de Saab tells Hedgeweek. “All our investment programmes are up on the year. Both pure implied volatility trades and implied versus realised volatility trades have produced positive returns so far.”

With markets galvanised on the back of reopening economies, de Saab is buoyant on the potential investment opportunities stemming from inflation risks.

He says that while investors were spooked by the prospect of an economic slump in the immediate aftermath of the coronavirus outbreak last year, the equities rally and attendant inflation risks have now heightened investor fears of a potential market downturn.

“Nervous investors buy options which keeps volatility expensive, so we expect the environment to remain supportive for the foreseeable future,” he continues. “Furthermore, inflation leads to higher rates and liquidity constraints which, with a 12-month lag, keeps volatility elevated and expensive.”

Launched in 2004, Cassiopeia’s market neutral, defensive investment approach – which treats volatility as an asset, using equities and derivatives instruments – has enabled it to generate uncorrelated positive returns, particularly during market dislocations.

“Having a positive drift with large returns during market turmoil is ‘defensive alpha’ that is very similar to what bonds offer,” he continues. “This is different, however, from a pure long volatility strategy which is more of a convex ‘hedge’ than a ‘bond’ – it typically exhibits negative correlation to equities and often ‘bleeds money’, or has a negative drift.”

Heading into 2021’s halfway point, de Saab says investor appetite for volatility strategies is strong, noting their ability to deliver returns during times of turbulence.

“Most investors are more attracted by the potentially large returns that volatility strategies can deliver in a crisis than the moderate returns it can produce during quiet times,” he suggests. “This is because there are simply too many other alternatives – such as digital assets – to make great returns in a bull market, whereas there are less choices for defensive investments.”

He adds: “Whether investors should opt for a pure long vol strategy or an arbitrage strategy like ours depends on their preference. Our research shows that it makes sense to hold both, as long as those are actively managed strategies.”

Established in 2004 by ex-Lombard Odier head of US and global equities Michel Dominicé, the company has roughly USD1.2 billion in assets under management across as assortment of volatility, equities and real estate funds and wealth management services.