New York-based Capstone Investment Advisors, a $US3.6 billion hedge fund, is having a huge month thanks to the market mayhem.
Capstone, a volatility hedge fund founded by Paul Britton, runs a number of portfolio protection funds that seek to profit from wild moves in asset prices.
One of the smaller funds in the firm’s tail risk strategy has delivered a 55% return so far this month, according to a person familiar with the fund’s returns.
Across that strategy, Capstone manages $US600 million. The 55% is for one of those funds.
The firm’s bigger $US3 billion flagship volatility arbitrage fund return 1.2% so far in August, according to the person.
The purpose of a tail risk hedging strategy is to limit losses from an outsized market event. The strategy involves buying options in equities, fixed income, commodities, and currencies.
The majority of those returns happened in the last week due to market turbulence, according to the person familiar with the returns.
Capstone declined to comment.
How does it work?
Volatility hedge funds like Capstone capitalise on volatility, or the variation of prices. The key measure of volatility is the Volatility Index, or VIX, which uses
option prices to gauge expectations of volatility. On Monday, the VIX hit its highest level in four years as markets got clobbered.
The last few days have been ideal for the small group of funds that seek to profit from spikes in volatility. Business Insider’s Ben Moshinsky reported on Tuesday that London-based volatility fund 36 South, whose Black Swan strategy gained an astonishing 234% in 2008, has seen some of its “best performance” in the last couple of years.
Think of it as insurance
The simplest way to explain how a volatility fund makes money is to think of it as buying insurance.
Let’s say that you have driven your car for five years, and never had a crash. At that point, insurance is cheap.
Then you crash and your insurance premium jumps.
Funds like Capstone buy insurance when it is cheap, or when nobody expects a market crash. Then they sell that insurance when markets have started to wobble and insurance premiums have started to get more expensive.
It’s simply a different strategy from traditional long/short equity hedge funds we usually talk about.
A difficult four years
The volatility strategy has faced challenges over the last few years though as central bank monetary easing programs and a surging stock market have kept a lid on volatility.
That meant a lot of the volatility funds lost money buying insurance for a crash which never came.
That all changed this week.
The Vix spiked to its highest level since 2009 as concerns over China rocked global markets and the Dow went on a historic slide on Monday.
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