“Think Different!” It is the only way to attempt to systematically reach for higher returns.
The investment management team at BrightView Capital Management has been managing capital since the mid 1990s. During this time, they have traded most asset classes, utilizing both fundamental and a myriad of technical analysis approaches. Of all the asset classes traded, the team has by far been most excited about volatility. Volatility is an exciting new asset class, which describes trading the volatility, or degree of movement, of the price of an underlying instrument, such as the S&P 500, rather than the price itself.
Volatility has unique characteristics which provide considerable advantages over other asset classes including being range-bound and mean-reverting. This makes volatility generally easier to predict than stock price. Importantly, volatility also has significant structural elements that regularly provide a tailwind, perhaps greater than any other asset class, that increases the probability and degree of potential success. Thus, an investment in volatility may appreciate and recover losses more quickly than one in say stocks. Investing in volatility also provides a way to potentially earn a return from an asset class that is not solely reliant on interest rate policy, earnings or even price appreciation. Since the volatility of returns of an asset class can behave independently of the asset itself, opportunities exist to diversify a portfolio by investing across both an asset and its associated volatility.
Accepting downside exposure is a valuable source of long-term reward in equities and other asset classes that has historically provided strong risk-adjusted returns. Investors are likely to earn higher long-term returns for bearing downside risk, as is demonstrated by equity investors having the potential to earn a higher return than bond investors over the long-term. Alternatively, investors that hedge their downside risk remove much, if not all, of their long-term returns through this added cost.
The volatility risk premium is compensation that hedgers pay to speculators to entice them to offset the risk of volatility in their portfolios. With options, volatility risk premium is part of the premium paid to option sellers who generally profit since the implied (expected) volatility of options tend to overestimate their subsequent realized volatility (around 85% of the time with the S&P 500). Similarly, and relevant to how we like to trade volatility, VIX futures tend to overestimate future spot VIX. This results, for example, in the price of VXX, a long volatility exchange traded note, relentlessly being driven towards zero—since 2004 it is has lost approximately 99.9999% of its value. It can be quite profitable to regularly take the opposite side of this trade, and benefit from the significant structural tailwind.
Selling volatility is similar to the successful business model of insurance companies which regularly collect overstated insurance payments (similar to a volatility risk premium) with the expectation that periodically there will be exposure to claims (volatility spikes). While a simple buy and hold short-volatility approach can potentially provide out-sized (in excess of 100% per annum) investment opportunities during favorable periods, it also exposes an investor to potentially large drawdowns. Instead, a more sophisticated risk-management based approach that alternates between being short and long volatility and cash, when appropriate, can be a more favorable way to approach volatility investing. In other words, collecting insurance premiums during quiet times and exiting the insurance business without commitment before forecasted storms hit. And at times maybe even qualifying to collect on windfalls on insurance obtained just days before. Being tactical helps minimize drawdowns, and can even turn what will be crisis for most equity investors into a two-fold out-sized opportunity by first capitalizing on rising volatility and then shorting heightened volatility.
By seeking to harvest the volatility risk premium when it exists, an investor can invest purely quantitatively, and does not need to make market predictions. So, during periods that the S&P 500 is bullish and sometimes when it is neutral, an investor can generally benefit from selling volatility. Conversely, during bearish periods where there is no volatility risk premium, an investor should seek to profit from an increase in volatility.
BrightView’s Volatility Strategy has been in continuous development and improvement since early 2011, just after when short volatility exchange traded products became available to trade in December 2010. The firm’s research, analysis, testing and improvement is expected to continue in perpetuity. BrightView utilizes a quantitative (rules-based) approach to investment management. Thus, it is able to analyze and stress-test how would-be sub-strategies would have performed in different market environments as far back as 2004 when VIX futures began trading. This can give a glimpse into the likelihood of future outcomes, and help assess risk before risking actual capital. This is something most investment managers are not able to do, and it provides sustainable statistical advantages over discretionary investment approaches.
While most volatility strategies utilize only a single approach, BrightView’s composite approach utilizes more than 50 independent volatility sub-strategies, each very good on its own. Utilizing so many strategies helps to smooth investment returns, and provides a long-term correlation with the S&P close to the optimal value of zero. The BrightView Partners Fund’s boutique size offers further advantage by allowing for more nimble trading approaches over large investment institutions. BrightView has found the sweet spot niche.
After more than a decade focused on volatility, the team at BrightView has the experience and expertise to manage risk and take advantage of the market opportunities that will come. BrightView believes that it’s Volatility Strategy will allow it to provide market-beating returns during the bullish portion of the equity cycle, and positive returns during the bearish portion, with far lower cycle drawdowns than the S&P 500. Successfully achieving a higher compounding rate can lead to a meaningful difference in the growth of capital over time. This is particularly important at this point in the market cycle where after a long bull-market, S&P 500 valuations are similar to those at the height of the 2001 Internet Bubble. The last century of the stock market reminds us that when valuations reach such lofty heights, that the ten-year forward expected annual return is less than 0%–what may become another lost decade. It’s reasonable that because of volatility’s attractive characteristics, that it can outperform the S&P 500. And we at BrightView believe that our Volatility Strategy can do even better than that.