Volatility mispricing ripe source of profits, says Malachite

Poorly constructed ETFs, risk-averse insurers and straitened banks are distorting volatility markets. Malachite is one fund designed to pick up the profits

The market is fairly bad at pricing volatility and it is getting worse, according to two former Goldman Sachs vice-presidents who founded an equity volatility hedge fund to exploit these inefficiencies.

"I firmly believe more people will end up doing it," says Jacob Weinig, portfolio manager and founding partner of Malachite Capital Partners. The fund returned 14.5% to investors last year and was dubbed the most innovative fund by judges at Hedge Funds Review's Americas Awards 2015.

While other volatility funds exist, many simply take levered bets on whether equity markets will go up or down or if volatility will go up or down; others are systematic quant funds. Malachite is market-neutral and puts its traders, rather than algorithms, in charge.

Weinig formerly ran Goldman Sachs' global institutional derivatives sales team in New York, while co-founding partner Joseph Aiken spent six years at its equity derivatives strategies group. Chief finance officer Mike Kostolansky was formerly chief financial officer at Spartus Capital Management, another equity volatility hedge fund.

The most important thing is to understand who else is in the market, buying or selling volatility products, says Weinig. "Is it above or below fair value? Is this persistent? Why are banks making money [from this]? We want to spend time understanding the story."

Predictable factors

The factors driving mispricing are different in each region but they are somewhat predictable. Systematic quant funds cause "significant flows" in Europe; Asia is a big market for structured products, bringing down longer-date volatilities; US funds predominantly choose to go long on index volatility.

"If you're a long-only fund, a large-cap hedge fund or a bond fund [in the US], you are buying volatility: you are buying S&P puts or Vix calls or vol spreads as your hedge. It is the cheapest and most liquid thing out there," says Weinig. "The question is how to take advantage of this, knowing the rest of market is aware of this?"

Part of Malachite's advantage is that financial markets are becoming less efficient at pricing volatility, the team maintains. They point to regulations on banks and insurers, and a wave of poorly constructed indexes and exchange-traded funds (ETFs) as responsible.

Higher capital ratios and the Volcker rule mean banks are pulling out of volatility arbitrage and index arbitrage. Solvency II means that insurers are more risk-averse and hold safer assets. But volatility is being priced differently for more abstruse reasons. A bank may sell a retail product and approach its limit to an exposure to a given risk, whether a correlation risk or a vega limit. It may buy a volatility product simply to ease balance sheet costs.

In January 2014, for example, the MSCI Emerging Markets Index fell 7% as the Argentinian peso and Turkish lira sank. Banks bought volatility on the index to such an extent "it didn't make any sense", says Aiken. Malachite sold straddles on emerging markets and bought straddles on eight single-country ETFs in a weighted manner, and was rewarded for doing so.

"The liquidity in the underlying products is going up dramatically but the efficiency is going down," says Aiken. He reckons that markets will take a long time to adjust to these fundamental regulatory changes.

Popular ETFs that provide too rough a proxy for equity markets can also create arbitrage opportunities. Blackrock's iShares MSCI Emerging Markets ETF is the "proxy for everyone to trade emerging markets", says Aiken, but it is only an approximation. He lists a number of imperfectly constructed exchange-traded products issued by banks with "naïve rules" that had been profited from, including Credit Suisse's TVIX exchange-traded note.

About a quarter of the underlying equity indexes on which Malachite trades are retail indexes created by banks; the rest are "vanilla" indexes such as the S&P 500 and those from FTSE. Roughly 60% of vanilla indexes are North American, 30% Asian, 5% European and 5% emerging markets. The fund trades Vix options, variance swaps, volatility swaps, as well as options on these swaps.

Risk buckets

The hedge fund has three risk buckets, to reduce correlation to equity markets. The volatility risk premium (VRP) strategy performs well when volatility is low, statistically long vol (SLV) performs well when volatility is high, and the special situations strategy is an arbitrage strategy.

The first aims to sell equity volatility in the short term but with tail risks kept as low as possible. "As a hedge fund we cannot tolerate tail risk," Aiken says. "Another fund that we know... said they once bought call options and made 15% in one day when Google announced earnings [but] how much were you risking to make 15%?"

The second bucket aims to buy equity volatility but with no or small negative carry – a Holy Grail for volatility buyers. The fund takes positions on volatility of volatility; it buys volatility where it is artificially depressed – for example, by structured products in Asia.

The third bucket is non-directional and opportunistic; it usually works well when positions are unwound in distressed conditions. Not a great amount of opportunities come from volatility arbitrage in mergers and acquisitions, Aiken says; these markets have grown more efficient in recent years. The ripest fruit comes from retail structured products and ETF arbitrage across borders.

In 2014, a year of low volatility with a spike in October, 8.5 percentage points of Malachite's returns came from VRP, 5.5 percentage points from SLV and 100 basis points from special situations.

Malachite Capital Partners won Most innovative hedge fund at the Hedge Funds Review Americas Awards 2015.