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“A waiting game”: Why veteran volatility hedge fund 36 South embraces uncertainty

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The current market uncertainty and value discrepancy offers the biggest opportunity in volatility-based trading in a generation, according to Jerry Haworth (pictured), the chief investment officer of London-based 36 South Capital Advisors, who is preparing a new fund to capitalise on further volatility shocks up ahead.

The current market uncertainty and value discrepancy offers the biggest opportunity in volatility-based trading in a generation, according to Jerry Haworth (pictured), the chief investment officer of London-based 36 South Capital Advisors, who is preparing a new fund to capitalise on further volatility shocks up ahead.

In a wide-ranging interview with Hedgeweek, Haworth discussed options volatility trading in the current environment, explained his views on why bonds have lost their efficiency as a hedge, and spelled out plans for a new strategy launch later this year.

Established in New Zealand in 2001, later relocating to London in 2009, the long-running firm is well-known for its volatility- and tail risk-focused model, which has generated eye-catching returns from market ruptures over the years by trading cheaply-priced long-dated options.

“Great opportunities”

With the fallout from the Covid-19 crisis set to loom large over the global economy for some time, volatility is forecast to remain at elevated levels, which makes Haworth particularly buoyant on the prevailing investment landscape.

“To say I’m excited is an understatement,” the ebullient Haworth said in a recent interview. “I haven’t seen a discrepancy in value, especially in the currency volatility market, this big in 30 years of trading. We just had an equity left-tail event, and there are great opportunities in the vol space.”

Reflecting on this year’s downturn brought about the coronavirus pandemic, which shook equity markets and hedge funds alike, he suggested few assets display “the true characteristics of a good hedge” more than volatility trades.

One common misconception among investment managers is the belief that strategy diversification alone provides enough insurance in a portfolio.

“A lot of people don’t hedge their portfolios because they have behavioural bias against negative carry,” the veteran volatility trader and derivatives markets specialist explained.

“Diversification works to a certain extent, but if you are trying to protect a portfolio for a long period of time, it’s not going to help you. To my mind, it’s like you live on the Thames and you build a three-foot wall at the bottom of your garden to protect you against the worst of the last 20 years of flooding. In all likelihood it going to be hopeless against at least one of the next 20 years of floods.” 

In contrast, volatility provides negative correlation to other assets, as well as convexity and asymmetry. 

“In layman’s terms, you pay a little bit every year for the wall, the worse the flooding the higher the wall gets (convexity and asymmetry),” he explained. “There are very few assets in the traditional investment space that does this. To my mind the volatility market is the only place where you can get these.”

A preferred habitat

Turning to how the current market backdrop has unfolded, Haworth believes that bonds have ultimately lost their efficiency as a hedge.

“Bonds as a diversifier in a portfolio have lost the great characteristics that made them so great up to this point, in that prices would rise as equity markets fell,” he noted. “I believe bond prices are so high now, and yields are so low, that all the upside has gone and all you have left is downside. The traditional 60/40 portfolio is actually running a lot more risk than it realises.”

Instead, the true diversifying assets are found in the currency, commodities and volatility markets. Of those three, volatility has the characteristics – decorrelation, asymmetry and convexity – that makes it perform best as a hedge, he added. “That’s why it’s more important than ever that people have a look at this space.”

The volatility investing sphere has historically comprised two main areas: volatility arbitrage, which is predominantly short-dated, and longer-dated options, which is anything greater than two years. The latter is the “preferred habitat” of 36 South, Haworth said.

“The reason for that is that long-dated options tend to be massively undervalued when volatility is low. When vol is high they tend to be massively overvalued,” he explained. “It also gives us enough time to be right, and it’s what sets us apart from others in the vol space.”

In contrast, a vol arbitrage strategy acts more as portfolio diversifiers rather pure hedges and, crucially, “won’t be able to produce the kind of returns a portfolio needs to in a systemic crisis.” 

High-octane returns

36 South does not comment on its funds’ performance. But Hedgeweek understands the firm’s main strategy, Kohinoor Core – which brings together elements of volatility options and macro investing – has recorded gains in the triple-digit territory so far this year, while the inflation/right tail risk-focused Cullinan strategy is up into the double-digits.

Looking ahead, 36 South is now also preparing to launch a new fund strategy to tap into the ongoing uncertainty.

The Kohinoor Carry Neutral Protection Fund will roll out in the second half of the year, targeting returns of 40 per cent when the S&P 500 is down by 30 per cent assuming other asset classes also move as expected, and net zero during normal market environments over a rolling five-year period.

“Quite a lot of our investors ‘get’ us, and they set aside an amount of money for high-octane returns when they need them. But there is still a large middle ground of investors who are looking for some sort of hedge but they want as low a carry cost as possible,” Haworth said of the reasons behind the new strategy.

“The new fund is tailor-made to what a lot of institutions and investors look for. The bleed is extremely low and yet the target pay-off is reasonable in a systemic crisis. This is still very much a portfolio of negatively correlated assets which have the characteristics of asymmetry and convexity.”

Reflecting on how the firm’s investment style balances sporadically-stratospheric gains with longer lean periods, Haworth said the process is ultimately “a waiting game”.

“Waiting for systemic events is not a strategy that you put in place and think: ‘I’m going to wait the next six months and if nothing happens then I’ll give it another six months’ then I will give up and try and time it myself’,” he said.

“We expect a vol regime shift about every five years. That’s why we prefer long-dated options. But not only does it give us enough time to be right, the expected returns relative to how much you outlay is always skewed in your favour.”

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