- Asset manager Ruffer LLP uses US50 cent options contracts to bet on rising market volatility as a hedging instrument.
- The fund says February’s stock selloff is likely to be a tremor and a bigger financial “earthquake” is only months away.
- Ruffer remains positioned to profit from an increase in volatility.
The market meltdown in early February — when US stocks had their biggest one-day fall in six years — proved to be more of a financial tremor, but the threat of an actual earthquake remains.
That’s according to Ruffer LLP — the British asset manager that was revealed to be behind a series of trades last year betting on a rise in market volatility, via the purchase of 50 cent options contracts.
In a quarterly investment note to clients, the firm’s co-founder Jonathan Ruffer said that if a more significant event does occur, it’s likely to be soon.
“We are confident that the earthquake will happen, more confident than we have been that it will happen in months, not years,” Ruffer said.
The $US20 billion investment fund made headlines last year by entering into around $US200 million worth of derivatives contracts based on the Cboe Volatility Index (VIX).
And the trades often expired worthless, as markets steadily rose amid an environment of record-low volatility.
However, the firm hit pay-dirt on February 6 when bond yields unexpectedly spiked, stocks tumbled and the VIX more than doubled in the course of one trading session.
The fund made a paper-gain of $US183 million on its 50 cent trades, after sitting on an unrealised loss in December of around $US200 million.
In his note to clients, Ruffer explained that the trades were used as a hedging instrument against the firm’s more traditional investments.
He said the company was positioned so that “if we lost large amounts of money in our equities and other risk assets, we would have made a correspondingly large amount in our volatility protection instruments”.
So while the fund made a tidy profit on its volatility bets in February, those gains for offset by similar losses in its other positions.
In the fallout from February’s market correction, questions about the extent of the market’s exposure to low-volatility trades was a key talking point.
And Ruffer says that if an “earthquake” does occur, “volatility will be a key issue in a market unwind”.
In effect, the extended period of low volatility has created a self-perpetuating cycle which spells danger ahead.
While equity volatility has remained low, asset managers have increasingly purchased more stocks — and as long as the “buyers keep buying”, the low-volatility paradigm will remain in place.
“This has meant that investors, either explicitly or implicitly, have come to believe the assets they own are safer than they actually are,” Ruffer said.
Until February, asset managers could rely on a stable environment where stocks rose steadily. In addition, equity prices generally moved inversely to bonds — which allowed for simple hedging strategies to reduce risk.
However, the events of February 6 showed that in an environment of rising interest rates, that negative correlation may not always hold.
As a result, Ruffer thinks “there’s danger ahead, and we have positioned our portfolios accordingly”.