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Market's pain is their gain

Volatility hedge funds thrive amid market turbulence, top rivals for first time in five years

Bloomberg News

NEW YORK -- Hedge funds that profit from turbulence in the financial markets are beating stock, bond and commodity investments for the first time in five years.

Volatility hedge funds returned 7.3 per cent this year through August, according to the Newedge Volatility Trading Index, which started in 2003. Hedge funds overall lost 4.8 per cent in the same period, according to Hedge Fund Research Inc. in Chicago.

"Nobody knows the direction of the markets or economy at the moment, and we're profiting from that uncertainty," said Trevor Taylor, co-chief investment officer at Miami-based Innovative Options Management LLC. The firm's $90-million (U.S.) hedge fund rose 12.3 per cent this year through August, after returning 25 per cent in 2007.

Price swings that helped Mr. Taylor started with the collapse of subprime mortgages that have left the world's biggest banks with $506-billion of writedowns and credit losses in the past year, according to data compiled by Bloomberg.

The S&P 500 fluctuated by more than 1 per cent on 71 trading days this year, the most since 2003 and exceeding the 61-day annual average since 1928, said Howard Silverblatt, an analyst at S&P in New York. The index may have its most volatile year since 2002, when there were 125 swings of more than 1 per cent.

There are about 50 volatility hedge funds globally managing a combined $9-billion, according to Newedge Group, owned by Paris-based Société Générale SA and Crédit Agricole SA.

The funds seek to make money from buying and selling options contracts on securities and indexes. Traders usually purchase options when they expect market fluctuations to increase and sell the contracts when they expect it to fall.

Options give the right to buy or sell a security for a certain amount, the strike price, by a given date.

"They make money when others don't. They act like insurance in one's portfolio," said Antonio Munoz, chief executive officer of New York-based EIM Management USA, a unit of EIM Group of Nyon, Switzerland, which invests $15-billion in hedge funds and has held volatility funds since 2002.

"The story for the next year to 18 months is going to be problems moving from Wall Street to Main Street," said Thomas Felgner, 36, a portfolio manager at Morgan Stanley's FrontPoint Partners LLC, a $10-billion hedge-fund firm based in Greenwich, Conn.

Volatility has risen as analysts' accuracy in predicting U.S. profits fell to the lowest level in at least 16 years last quarter. "There's more uncertainty about corporate profits in the next few quarters and that in itself is a positive for macro volatility," said Abhinandan Deb, an equity-derivatives research analyst at Barclays Capital in London.

"If there are surprises to estimates, and we think that's more likely than not, that would boost volatility."

The outcome of November's election in the United States and the resulting economic policy may heighten market turmoil, said Al Wilkinson, a former director of the Chicago Board Options Exchange who led the group that created the VIX index.

"We're going to be in an environment of elevated volatility for the next two years or so," said Mr. Wilkinson, 49, who runs Sydney-based Pengana Capital Ltd.'s Global Volatility Fund.

"It's going to get dicey."

While analysts and traders expect volatility to remain above historic levels, the VIX has fallen 31 per cent from its five-year high in March.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested.

Managers of volatility funds have shorter track records, making it difficult to assess whether they generate consistent returns, said David Bailin, president of Bank of America Corp.'s Alternative Investment Solutions group in Stamford, Conn., which invests in hedge funds.

"Until managers have a proven, long-term, successful strategy, we're unlikely to invest," he said.

By the numbers

-15% S&P 500

-10% S&P/TSX composite index

7.3% Volatility hedge funds

-4.8% All hedge funds

-8.4% Average U.S. equity funds

-4% Corporate fixed-income funds

-6.4% Basic-materials stock funds

U.S. funds, year to date, as of Aug. 31


The most common way to trade volatility is by using S&P 500 options, the most active U.S. options family, with more than 12.4 million existing contracts.

An investor who believes stock market volatility will decrease may sell options. An example would be selling a "strangle," in which the trader creates and then sells a put below the current index level and a call above the index price. If the index stays between the strike price for each of the two options, the trader keeps the premium paid by the buyer. Call options give the right to buy and puts convey the right to sell.

"It's a tricky asset class," said Steve Gross, principal at New York-based Penso Capital Markets LLC, which advises clients on investments. "Given the complexity of the strategy, it's hard for even the most knowledgeable investors to understand it."

Bloomberg News, Hedge Fund Research Inc., Newedge Volatility Trading Index

© 2007 The Globe and Mail. All rights reserved.

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