Last spring’s exceptional market volatility proved the mettle of at least one set of strategies – volatility-focused hedge funds. The CBOE Eurekahedge Tail Risk Hedge Fund index returned a bumper 51.64% in the first three months of 2020 alone against a broad hedge fund market index return of -7.96%, and was up 34.8% for the year.
For New York-based hedge fund Capstone, such tail-risk hedging strategies form part of the firm’s $3bn (€2.47bn) solutions business, which started life in 2010. As the VIX rose in March 2020 – and the opportunity set of volatility-related opportunities broadened – one of the firm’s tail-risk strategies was reportedly up 350% over the first quarter.
Capstone – founded by CEO Paul Britton, a former options trader – emerged in 2004 from a buyout of Mako Global Markets. The firm spent the first three years of its life as a prop trader before the 2007 launch of its flagship Master fund.
The Master fund covers a variety of options and derivative-based strategies with 22 trading teams and a core focus on volatility. The solutions business typically provides defensive, tail-risk and long-volatility strategies to a mainly US-based institutional and pension fund clientele.
Firms like Capstone have built their reputation on allowing institutional investors to sleep more easily at night. Yet the 12-year bull run since the end of the 2008 global financial crisis and relatively low levels of market volatility – together with disillusionment over hedge-fund fees and performance – have prompted Capstone and others to diversify their business models.
In Capstone’s case, this has meant building out a global trading infrastructure – effectively adding new strategy legs and broadening the opportunities available to the Master fund and solutions capabilities.
Britton says: “That was always my vision, that I felt was going to be our competitive edge. Building a global infrastructure enables us to view every asset class across every region, but it’s an enormous undertaking.”
It is also a costly one. With less than $10bn under management, Capstone is no Millenium or Citadel, and its mainly institutional client base is highly fee-sensitive. Getting the balance right is also a problem – over-spending could be disastrous.
Britton says: “I understand I can’t just pocket these nice management fees. The management fees are there to be able to run the business but in my view, most importantly, to invest in the business, so that you’re remaining innovative, you’re remaining relevant. Alpha erodes so quickly today that you just need to ensure that you are constantly innovating.”
Macro calls are not part of the DNA of a volatility-and-relative-value-trading firm like Capstone – “we’re market structure folks” as Britton puts it. Yet engagement at some level is important, particularly where client solutions are involved with the associated need to understand what will help institutional investors sleep better.
Britton argues that asset owners have just had the “biggest windfall in generations” – 20 years of returns compressed into 12, as he puts it.
Now, as $30trn of stimulus has effectively “eliminated fixed income as an asset class”, investors are at risk of structural imbalance in their portfolios and of a 1994-style bond meltdown.
“Let’s have a proper dialogue around how to build portfolios that ultimately are well risk-adjusted with the acknowledgement that we’ve lost, ultimately, the utility function of one of the most important pillars of your portfolio,” Britton says. “We’ve ended up in a situation where there’s no such thing as a 60/40 portfolio.”
Fears of inflation are also growing – as seen in the steepening of the curve at the long end. Stimulus will be tapered and withdrawn at some point. The problem is no-one really knows when.
The CEO also notes that despite the stellar heights of market indices, liquidity as measured by the depth of the S&P 500 futures market is at record lows. Despite the general “hosepipe” of liquidity generally, bank balance sheets have contracted, with persistently low aggregate reported value-at-risk. Despite the good intention of creating a safer banking system post-2008, this leaves markets in a brittle state and sensitive to elevated levels of volatility.
What are the lessons of all this? “I’m hoping one of the outcomes is an acknowledgement that we have a problem with market liquidity, which is going to continue to drive very, very unusual price movements across the marketplace, and which I don’t think ultimately is healthy for the market,” says Britton.
“It doesn’t inspire confidence in the market. And ultimately, as a practitioner within a market, I want a system that is safe, reliable, [that] investors can trust. Ultimately, if investors need to transfer risk in an orderly fashion, they have the ability to be able to do that without affecting the marketplace significantly.”
Long-horizon investors may just choose to ride out future volatility, but crisis alpha or tailrisk strategies may prove interesting to those looking to smooth out any bumps.
Capstone has also joined the many voices arguing that well-constructed portfolios of hedge fund strategies can make a credible substitute for some of the bond allocation in a traditional portfolio.
Volatility risk premia strategies – along with other hedge fund risk premia, like momentum, carry and value – would have a place here.
“You can make a very strong case that certain options, like index options, are just structurally overpriced because you have large institutions hedging [due to] regulatory reasons. So there’s a structural proposition there,” Britton says.
Foremost on the CEO’s mind right now is expanding the capabilities of the Master fund: “Our largest capacity constraint for flagship is just finding the best talent, to be able to make sure that any talent that we bring on is creative to flagship,” he says.
“Market structure folks” are predominantly white and male, and Capstone is not alone in struggling with issues of diversity on its trading teams. All 18 members of its UK partnership, for instance, are men.
Britton acknowledges that this is an issue, but also points to his firm’s backing of the UK’s 10,000 Black Interns initiative.
Just as Capstone seeks to change the portfolios of its institutional clients, it is also adapting to a new world where diversity among teams is not just hoped for, it is expected.