In the US and Europe, an increasing number of investors, and some corporations, have woken up to the potential of volatility as an investable asset class that provides effective hedging and, hopefully, profits in difficult market conditions. A strategy that is particularly appealing in times of extreme market turbulence, volatility displays inverse correlation with traditional asset classes and has been making Western hedge funds money throughout the financial crisis.
The view from Asia is different. “Volatility as an asset class, and volatility hedge funds, are of limited interest for non-Japan Asian investors,” said Michael Wexler, founder and chief investment officer at Maple Leaf Capital, a volatility arbitrage hedge fund based in London, with a trading office in Hong Kong. “High-net worth and family offices in non-Japan Asia are typically mostly invested in their own real businesses, and property. Hedge fund acceptance is still less developed than Europe or the US, and initially that means simpler strategies — equity long/short — are gaining traction first.”
For those willing to consider it, however, Asian equity indices offer a fantastic opportunity for investing in volatility, said Wexler. “Asian equity indices definitely have enough liquidity to be useful for the typical investor or vol fund,” he said. The Kospi has been the second most liquid index in the world after the S&P 500, if only for spells, he said, and offers consistently impressive depth on screens and tight pricing.
“Nikkei is also excellent, and Hang Seng is also very tradable,” he added.
Yet investors have been put off the local Asian volatility indices because of the difficulty of getting simple exposure, said Emmanuel Machayekhi, head of index trading, EFS Asia Pacific, at Barclays. It has been hard to invest in volatility on Asian indexes directly due to the lack of local offerings and the relative illiquidity of volatility products in the region, he said. Instead, investors wanting to hedge Asian equity exposure have been most likely to buy volatility products based on the S&P, relying on correlation between the US and Asian equity indexes to ensure some level of protection.
This can be a profitable strategy, said Wexler, if investors are willing to accept the basis risk in exchange for the tighter bid-offer and huge depth, which can be necessary if hedging a multi-billion long-only portfolio for example. “It’s probably just fine if you’re trying to hedge tail risk,” he said. “Crash correlation is extremely high, and the extra noise can work for or against.”
Yet investors wishing to buy and hold volatility for duration have fewer options. “The premiums for buying and rolling outright puts on a systematic basis have been just too high. It has acted as a negative bias in the portfolio,” said Machayekhi. “Investors are looking for an alternative cheap exposure that will not cost a lot when volatility is low but will make money when volatility spikes.”
Now, perhaps the first signs of Asian investor interest in volatility are beginning to emerge, with the launching of the first exchange-listed pure volatility products in Asia. In February the VHSI and VNKY futures launched on the Hong Kong and Osaka exchanges respectively, the first exchanges to list pure volatility products based on local Asian indices. “As there is no unique equity index that covers the major names across the entire region, it was difficult to establish a single Asian `fear gauge’,” wrote Barclays Capital in a note published in anticipation of the index launches. “The upcoming VHSI and VNKY will be the most representative.”
The launches of VIX ETNs and dynamic VIX indices in Asia should make volatility an asset class that investors can buy and hold, enhancing their returns and their risk profile, said Machayekhi. The equivalent products in the US performed as expected during times of market stress, for example August 2011, which meant investors that were long volatility profited when other asset classes were recording losses. This should encourage Asian investors to consider these volatility products as a hedge in the future.
Barclays has launched its own Vix ETNs in Japan, the first such products to be tradeable inside Asian business hours. The products offer cheaper exposure to volatility than was otherwise available, said Machayekhi.
The ETNs use VXX and VXZ as reference for short- or medium-term exposure.
Investors like the liquidity of Barclay’s Tokyo-listed iPath exchange traded notes, which offer intra-day liquidity on VXX and VXZ during Asian hours, said Selim Piot, an equity and fund solutions structurer for Asia-Pacific at Barclays. They are easy to understand in terms of how they work and how they derive their price, he said. This is born out by their strong uptake, with $150 million flooding into the products since launch.
“Because of the steep term structure on SPX in normal market conditions, there is a high cost of carry on the VXX if the market is stable,” said Piot.
This meant investors could incur a loss if they wanted to hedge against future volatility in a market that was not actually volatile, he explained. The notes have very small transaction costs and do not require rebalancing, said Machayekhi, keeping costs down.
The VIX ETNs will also allow traders to take a view on future volatility and make money from very difficult market conditions. But there are dangers.
“Investors need to be aware of mean reversion,” said Machayekhi. There is a natural temptation to load up on volatility when the market is already volatile, and the price for that exposure is therefore relatively high, when in fact the best time to buy volatility is when the market is calm.
In due course Barclays hopes new volatility products will be launched by Asian exchanges, although they will only be on the most liquid indexes, with Korea, Australia and India cited as three possibilities, though there are no imminent plans for these launches, said Machayekhi.
This article first appeared in the June issue of FinanceAsia magazine.
