08.08.2011
By Terry Flanagan

Volatility: An Asset Class or Quick Buck?

The CBOE Volatility Index, commonly referred to as the market’s “fear index,” has had a one-day range of 27.54 to 39.25. As the past week showcases a near 30 percent change in the VIX, market participants wonder if the great volatility era has returned.

“Institutions have increased interest in volatility, not the VIX per se, but more so, hedging tail risk,” said Warren Mosler, co-founder of AVM L.P, a provider of brokerage, trading and administrative services to its affiliates, one of which is eponymous hedge fund III Associates, based in Boca Raton, Florida.

Mosler, currently a resident of the U.S. Virgin Islands, is also running for U.S. Senate in 2012, and a published economist.

“There are programs out there to hedge tail risk when extremes happen because people want to be protected,” Mosler told Markets Media. “Out of the money options have gone way up, and they’re going to stay high for a long time. There has been a real shift of money into these strategies.”

Ironically, Mosler noted that increasingly used practices, such as tail hedging are propelling more volatility in the markets, causing a pro-cyclical self-fulfilling prophecy in the markets. Investors create fear to protect themselves from fear.

Despite an increased institutional interest in utilizing volatility, it remains to be a measure of protection, not a standalone asset class, for fund managers.

Volatility is traded more but it’s not an asset class by traditional definition, according to Mosler. “It’s a money-making activity, a way to hedge a position, a way to express one’s view.”

Josh Parker, managing partner of Investment Strategies at The Gargoyle Group, agrees.

“Volatility doesn’t do anything to protect against long-term real inflation, or against currency risk, or against rising interest rates…if you look at it that way, it’s hard to see it as a traditional asset class,” said Parker.

Gargoyle architects options strategies and overlay programs to portfolios as a risk management tool. Currently, the firm still implements derivatives as means to hedge investment—not make a quick buck. Parker confirmed that the latter is a strategy better employed by short term traders, not the traditional buyside.

“We use options really solely to hedge an equity portfolio, not as separate investments, but we know that there are side benefits in adding return to a portfolio’s bottom line,” Parker noted.

Undoubtedly, an increase in VIX trading and overall market volatility levels in the past week has propelled interest in Gargoyle’s option overlay programs.

“Yesterday, from 3:45 to 4:15, I calls from clients and consultants alike asking me to pitch our services to them. They’re all scurrying to hedge,” Parker said.

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