In Brief

• Volatility is a key determinant in the opportunity set for alpha-focused strategies. Average-to-above average levels of volatility create healthy dispersion which Relative Value and Quant managers can exploit to generate returns.
  
  
• Today, and for the foreseeable future, we think markets will remain in the sweet spot of volatility driven by uncertainty around Covid-19, the U.S. Presidential Election and the re-emergence of retail investors.
  
  
• While extreme monetary policy could put downward pressure on volatility, large March losses in short vol strategies should set a higher volatility floor than in the recent past.

Volatility is key in determining the attractiveness of alpha strategies.

Consider three broad regimes:

1. Below average volatility (VIX < 15): Limited dispersion and tighter performance amongst similar assets. Fewer opportunities for alpha strategies to profit, positive for equity and credit beta exposure.
   
   
2. Average to above average volatility (VIX ~15 to low 30s): Choppy trading and high dispersion. This is the optimal environment for Relative Value and Quant strategies which seek to identify mispricings and mixed for equity and credit beta exposure.
   
   
3. High volatility (VIX >32): Sharp trends and reversals. Poor environment for alpha and beta as correlations spike and high-to-extreme volatility can cause investors to reduce risk, locking in losses.
    

Today, and for the foreseeable future, we see markets in Regime #2, the sweet spot for volatility. This should be a welcome development for investors looking to add alpha and diversification into their portfolios given elevated equity and core fixed income valuations, We expect hedge funds to build upon an already strong 2020 into 2021. This view is informed by several key factors and events which we describe below.

Factors driving volatility from now until 2022

Continued uncertainty regarding Covid-19

We are now more than ten months into the pandemic and markets continue to react to caseloads, reopening plans and potential vaccines. Chart 1 on the next page shows the relationship between Coronavirus Google searches and equity market volatility: year-to-date, the correlation is 0.91. While this relationship will weaken over time, we expect periodic spikes well into 2021 driven by overly optimistic expectations regarding a widely distributed vaccine, the colder northern hemisphere weather limiting outdoor social distancing opportunities and the challenges related to starting the 2020-2021 academic year.

The U.S. Presidential election

The election will create both short term volatility and implications for markets into 2021 and beyond. In Chart 2 you can see an expected volatility spike around the election and for vol to stay elevated well beyond November 2020. We’ve included the 15 VIX level as a reference. The election is expected to be close and given record levels of mail-in voting, we may not see a winner declared on November 3rd. There is also the more extreme scenario whereby President Trump refuses to accept the results of the election. Either case would undoubtedly introduce further volatility into markets. It’s not just the executive branch of U.S. government that is being contested though. Just as important are the Senate races in which the Democrats could take a majority.

The election will create alpha opportunities beyond 2020 as well.

• If Democrats win the Presidency and both houses of Congress, there will be significant legislative changes that will create sector winners (infrastructure and renewable energy) and losers (oil and gas and low tax rate industries).
  
  
• If the status quo prevails (Trump wins, Republicans keep the Senate and Democrats keep the House), further escalation in a trade war with China along with escalating civil unrest is likely.
  
  
• If Trump wins and Democrats take both houses of Congress, the President’s use of unpredictable Executive Orders could expand and impeachment proceedings could be restarted.

In summary, all paths following the U.S. election are rife with uncertainty and opportunity for alpha strategies.

Chart 1: Coronavirus search activity has been the best predictor of volatility this year

Source: J.P. Morgan Asset Management; for illustrative purposes only.

The resurgence of individual retail investors

Post-GFC, retail investors largely stepped away from individual equities and options. However, year-to-date through June 2020, account openings at major brokerages are up 25% compared to full year 2019 and individual investors represented nearly 20% of U.S. equity trading volume, double the proportion of 10 years ago (Chart 3). Retail investors are generally less sophisticated and are a source of alpha as they stretch valuations and tend to enter and exit stocks at the same time. We are already seeing benefits from this trend in the results of our relative value and equity-focused managers.

Chart 2: The market expects volatility to spike around the election and remain high into 2022

Source: Bloomberg, as of September 29. December 2021 and June 2022 proxied with SPY implied ATM vol.

Chart 3: Retail investors have doubled their presence in equity markets

Source: Bloomberg Intelligence. 2020 data are for January through June.

What about the Fed?

Rates at 0% can push investors up the risk curve, ultimately leading to risk assets going up with little volatility. Why isn’t that the case this time? There are a couple of key differences in 2020.

1. This recession has been created by a global pandemic which will eventually be solved by the scientific and medical community. To be clear, rates will be low for years, but we expect the reversal of this ultra-accommodative policy to happen more quickly than post-GFC when it was seven years before rates increased even 25bps.
   
   
2. There are fewer investors selling volatility in 2020 as a result of losses in the space.
    

Selling volatility via options produces steady, uncorrelated returns until volatility picks up and devastates these strategies. It can also create an environment where bank dealers, a key intermediary in options markets, are forced to buy equities as underlying prices go up and sell when prices go down. This kind of activity pushes volatility to the extremes (high and low) and is not conducive to the sweet spot we described.

We do not invest in short vol strategies, but during March we watched from the sidelines as investors lost billions in these strategies. Short vol strategies breed complacency with their attractive Sharpe ratios and seemingly low correlations during benign environments. Investors that do not understand the tail in these strategies ultimately blow up. In March, this included not only funds but also several well-known and respected institutional investors that ran similar strategies. While the market can have a short memory, we don’t expect vol selling to come back in size soon, thereby raising the floor on volatility.

What should investors do about it?

Investors should revisit their allocations to alternative hybrids like hedge funds that can benefit from volatility. Hedge fund strategies that we are overweight include Relative Value and Quant, which should benefit from the volatility outlook we described. These strategies thrive in an average to above average volatility environment as healthy dispersion within and across sectors creates opportunities to profit on market neutral trades. Quant specifically should be considered by investors seeking diversification from equity beta and factor risks(value, growth, momentum, etc.). Should volatility surprise to the upside, our portfolios will benefit from our increased allocation to Macro managers.

We continuously seek strategies that complement our portfolios and we structure our investments to provide our clients with the most favorable access points and terms. We are confident that our strong results in 2020 will continue into 2021, as volatility creates a fertile backdrop for alpha strategies. Of course, manager selection is paramount in alternatives, so we would be happy to discuss a potential partnership to complement your existing resources.

Arbitrage strategies are highly complex. Such trading strategies are dependent upon various computer and telecommunications technologies and upon adequate liquidity in markets traded. The successful execution of these strategies could be severely compromised by, among other things, illiquidity of the markets traded. These strategies are dependent on historical correlations that may not always be true and may result in losses. Investors should consider a hedge fund investment a supplement to an overall investment program and should invest only if they are willing to undertake the risks involved. A hedge fund investment will involve significant risks such as illiquidity and a long-term investment commitment.

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