Hedge Funds ≠ Long Volatility

In reference to the Fortune article from earlier this year titled, “If you don’t freak out soon, Paul Tudor Jones won’t make his 27%” by Stephen Gandel, and the glib interpretation that hedge funds merely provide a “long volatility” exposure, the following is an attempt to dispel that myth and better articulate the importance of volatility in alternative asset management.

Not that the article in Fortune committed the original sin on this topic - I’ve heard similar representations in the past – but this piece crystalized an inaccurate impression that has been used to impugn lots of strategies, from long/short equity to managed futures.  As a final preface, I’d like to note that this is a defense which, clearly, Paul Tudor Jones doesn’t need my help on.  From the article:

"My notion of a hedge fund is that it is a series of sophisticated, targeted bets on stocks or bonds or some portion of the market….

But if you listen to Jones, that’s not what you get when you invest in a hedge fund at all. What you are really getting, if Jones is right, is a one-way bet on volatility…

And it turns out, Jones, a three-decade veteran of the hedge fund business, is right. Hedge funds tend to do well in years in which volatility is rising. And they suck wind in years when it is not…

The bigger problem for hedge funds is this: There are now much cheaper ways to bet on volatility…

If you are looking to lose money, and considering investing in a hedge fund, the VIX funds are a much cheaper way to do it."

Quickly, we need to define our terms.  Being long of anything, be it a security, derivative, or variable exposure, means quite specifically that a benefit is derived from an increase in the element.  In one example, if the S&P 500 moves from 2000 to 2200, an unlevered long position gains 10% (plus reinvested dividends).  If a long position is taken on some proxy for volatility, say the VIX, a benefit will be derived if and only if the position is initiated at lower VIX level than when the position is closed (and even then there are some technical issues which are detrimental to investors).

Being long volatility, as opposed to stocks, has never been a successful longer-term strategy.  This is because volatility is a second-order representation of the behavior of values of actual companies.  While volatility does gyrate up and down, it does so without the underlying growth of the economy that has provided a very long-term trend upward in equities.  Owning a basic long position in volatility is at best a short-term, tactical trade. 

More to the point, hedge funds don’t necessarily do well in periods of rising volatility.  Hedge funds, often engaged in relative value or arbitrage trades, are much more likely to do well during periods of high volatility.  The period during which volatility increases may or not be a profitable time for a hedge fund.  Rising volatility tends to imply declining equity prices, so it would follow that a hedged fund (one whose market beta is < 1) would outperform during a period of declining equity prices.  But more broadly, the value created by hedge funds isn’t primarily concentrated during those periods of equity decline, but rather during extended periods of higher volatility, wherein greater discrepancies between like-securities occur, and the arbitrageur can generate more alpha.

The difference between what hedge funds are actually capitalizing on and the claim in the Fortune piece is that being long volatility can only benefit an investor during the short bursts of increasing volatility.  It is different than an increase in prices in the following way:  A period of increasing stock prices benefits shareholders – plain and simple.  A period of high stock prices, say a year in which the S&P begins at 2300 and ends at 2300, will not benefit (aside from dividends) investors who are long the S&P.  Likewise, being long volatility during a year of high volatility, say a year wherein the VIX clocks in at 35 at some point each month, will not benefit investors who are long volatility, but it is likely to benefit strategies which profit in times of high volatility.

In conclusion, alternative investment strategies are more likely to prosper, relative to the market, in periods of high volatility, as opposed to periods of increasing volatility.  A nuance to be sure, but a critical one, and one that should illustrate why it is unlikely that return streams from hedge funds can be replicated by an inexpensive ETF.