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Increased Risk to Make a Minor Return

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...hedge funds may be somewhat de-levered from earlier years, but the types of trades being done by hedge funds are more risky than they used to be.

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Prof. Succo,

I find it interesting that the "volatility of the VIX" increases during periods of low volatility like the early-1990's or the past few years. This is probably just another way of saying that gamma increases significantly during such periods, which of course substantially raises the risk levels of those short premium.

It will be interesting to see how the new VIX options are priced. Calls should be pretty expensive, at least on an absolute basis. It will also be interesting to see if these new options create a "long volatility" constituency that puts upward pressure on premiums.

The initial decline off the 2000 top did not cause a major increase in volatility. It popped after 9/11, but then went into a steady decline until the market plunged in the second half of 2002, at which point vols surged. Do you recall the circumstances? I'm not remembering any major external events in that 2002 backdrop.

Finally, I thought you might find the following quote from a recent Grant's to be of interest if you missed it:

"The big trade over the past year-and-a half?" one hedge fund guy recently remarked to another, "selling risk premia."

Here's one for the capital markets edition of "Ripley's Believe It or Not." Hedge funds are supposed to hedge. Yet, if our anonymous informant is even partially well-informed, not only are they not hedging, but also they are taking the other side of the trade. They are selling credit protection and stock market volatility, not buying them.

Observing (volatility and credit risk) levels, you would almost suppose that the nation was at peace, the yield curve was positively sloped, the H5N1 strain of bird flu had been eradicated and the chairmanship of the Federal Reserve Board was not changing hands in two weeks."

Prof. Schaeffer

Prof. Schaeffer,

When hedge funds "de-lever," they may not be reducing risk. We have talked about this before and this phenomenon can be linked to "compression."

If Sheryl takes one dollar and buys two dollars worth IBM (borrows one dollar) while Sam takes one dollar and buys one dollar of Google (GOOG) (no leverage), who is taking more risk? Just because one is using leverage while one is not does not mean one has more risk than the other. In this case, one could say that the net risk is about the same because IBM tends to move about half as much as GOOG does on any given day.

But even this is only a linear comparison. There will be times (like when market volatility picks up) that buying IBM on leverage is more risky; there will be times (like when the volatility of GOOG picks up) that GOOG unlevered will be more risky. But again, this only looks at one aspect of risk. With the nature of GOOG's business (its stage as a growth company, its balance sheet, etc.), the tail risk (chance of a big move) is much greater for GOOG than IBM (this may not even be true for there may be a hidden problem at IBM that the market has not yet perceived).

The quote from Grant should be saved by every trader. I have repeatedly pointed this out to Minyans: hedge funds may be somewhat de-levered from earlier years, but the types of trades being done by hedge funds (creating synthetic income) are more risky than they used to be. I call these types of trades synthetic income because when they work they throw off a steady stream of profits; when they don't they blow up. Of course real income does not blow up; it can only go to zero. So synthetic income is not real income, it just looks that way to the naïve.

Synthetic income trades are trades like selling premium (options) against risky assets (like stocks). This trade is being done by the new "income funds," hybrid funds that are a little like hedge funds (they do use small leverage and are flexible) and a little like mutual funds (their capital is stable because they are set up as closed end funds and their investors are less sophisticated). Normally, they throw off nice profits in low volatility environments; when the market gets volatile they can experience significant capital losses. When hedge funds sell credit spreads, currency spreads, or buy convertible bonds and short stock and use leverage, when those spreads hold within a range, these trades can throw off nice profits; when the spreads break out or correlation increases while volatility increases, they can experience significant capital losses.

It seems to me that just about everyone has on the synthetic income trade: increased risk to make a minor return.

-Prof. Succo

No positions in stocks mentioned.

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