Long volatility strategies: hedge funds vs DIY
DIY is the best and worst financial advice for retail investors. On the one hand, retail investors are not particularly good investors and perhaps should not invest alone at all. For example, the eToro trading platform, which has more than 20 million users in more than 100 countries, reveals that 67% of their auto-trading clients lose money.
On the other hand, most retail investors would have generated higher returns in recent years if they had invested in index ETFs rather than entrusting their capital to financial advisers or mutual fund managers.
The evidence is less clear for institutions that consider replicating complex strategies on their own instead of hiring dedicated managers. Most hedge funds offer little more than factor exposure and can theoretically be replaced by cheap risk premium indices, but only a minority of institutional investors have done so.
Long volatility strategies are particularly complex given predominantly option-based portfolios, making due diligence and oversight of fund managers more expensive. The number of fund managers is also limited. A do-it-yourself approach might be attractive to institutional investors.
In this research note, we will compare hedge funds with a long volatility strategy to systematic replication.
Build a dynamic and systematic long volatility strategy
We use the CBOE Eurekahedge Long Volatility Hedge Fund Index as a benchmark for long volatility hedge funds. The index includes 10 equally weighted components, which include some of the most well-known managers in this space.
For the do-it-yourself (DIY) strategy, we measure the correlation of 59 asset class indices with the VIX and select the 10% with the highest correlation. The resulting portfolio was mainly made up of risky currencies, for example USD / CAD, and government bonds. The implementation would be efficient and inexpensive via futures contracts.
We observe that long volatility hedge funds provided a higher absolute return over the period 2006-2021 than the DIY strategy. However, we also observe that both increased when the stock markets collapsed i.e. during the global financial crisis in 2009 and the COVID-19 crisis in 2020, which highlights that both provided the desired negative correlation with stocks in times of crisis.
Hedge funds continued to generate positive returns between 2009 and 2012, but then lost all of those returns until the global pandemic struck. It would have been difficult to stay allocated to these managers during this period given the regular bleeding. The DIY index has been essentially stable throughout the decade between 2009 and 2020.