Market volatility looks as though it is here to stay, but there are ways that portfolio managers can invest in it and use it to their advantage
During the darkest days of the Great Depression, President Franklin D Roosevelt used his inaugural address to calm a nation in the grip of financial crisis. He identified the heart of the problem facing both the nation and the markets alike: “The only thing we have to fear is fear itself.”
Fear played a large part in the stock market collapse and, together with greed, it can determine the direction of markets, contribute to the formation of business cycles and, in extreme cases, be the foundation of both asset bubbles and their inevitable collapse.
Traditional investments are in effect a bet on future stability and growth so in trader parlance tend to be long-greed and short-fear. Within financial markets, volatility and fear are inherently linked fear causes volatility to rise and markets to fall. To make matters worse, when panic grips a market and volatility spikes higher, correlation between asset classes tends to increase, thereby limiting the usual volatility reducing benefits of diversification.
Fear within markets can directly lead to large and correlated losses across a portfolio but what if we could invest in fear itself?
Risk-assets are currently behaving in a distinctly bimodal manner, tending to either rally hard or fall quickly, leaving only a low probability of more moderate moves.

Back to the ’70s
The benefits of treating volatility as an asset class were seen as long ago as the ’70s, when the introduction of exchangetraded options gave rise to the possibility of creating a market in volatility.
By adding long volatility exposure to a portfolio, an investor can protect themselves against a severe downturn in the market.
Importantly, implied volatilities are nearly always higher than realised volatilities and the spread between the two, the variance risk premium, can be seen as the cost of buying insurance to protect against a rise in volatility. Over time, variance swaps proved extremely popular and led to institutional investors such as pension funds and insurers entering the volatility markets that had until then been the preserve of hedge funds.

Gauging fear
Implied volatility can provide useful insights into the market’s perception of future risk. The Chicago Board of Exchange Volatility Index (VIX), commonly referred to as the ‘fear gauge’, is a measure of the market’s expectation of the future volatility of the S&P 500 based on the implied volatility of its options.
As would be expected, the VIX displays a strong negative correlation to the S&P 500 and while it is not directly investable, in March 2004 VIX futures began trading on the CBOE Futures Exchange. To provide better access to this market, a number of exchange-traded notes (ETNs) linked to VIX futures have since been launched. In January, 2009, Barclays launched the iPath S&P 500 VIX Short-Term Futures ETN (VXX). VXX and similar ETNs are the latest in a long line of volatility-based products, designed to offer investors a source of returns exactly when they are most needed. Between 28 Aug and 27 Oct, 2008, the VIX rocketed from a level of less than 20 to more than 80. This move generated huge profits for volatility investors, at a time when most markets were plummeting. Even a more modest increase in volatility earlier this year led to VXX generating an 86% return between 21 April and 20 May.

Long volatility trades have been unattractive since the peak of the global crisis in 2008, but expectations of further market turbulence may tempt more to invest.

Cheyne Hedge Fund specializes in credit market investments and has won or been nominated for numerous awards from 2003 until 2009, many for its long short credit funds.

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