Demand for volatility-focused hedge funds has increased in tandem with rising worries about A-share price swings, despite global equities being largely unaffected.
Chinese volatility has, however, led to dampening demand for structured products, although Japanese demand for structured products is seeing a resurgence because of the Abenomics-inspired equities rally.
Low levels of volatility in recent years have made investors more comfortable about investing in structured products – which are typically short volatility.
“As long as you’re not worried that there’s going to be a precipitous market drop then you buy,” said one investment banker who designs structured products but declined to be named.
Structured product buyers often sell put options on indices (or bet against indices becoming more volatile) to enhance yield on the upside.
Recent second-quarter results from Swiss private banks highlighted a strong appetite for structured products, which had been slow to regain investor favour post-global financial crisis (GFC).
In Japan, sales of structured products were not as adversely affected by the GFC as they were elsewhere. This was partly because the Nikkei 225 stock index had languished at low levels for years – a situation which has since altered and is leading to changes in Asia’s biggest structured products market.
“When the Nikkei was at 10,000 investors were very willing to accept a knock-in at 60-65% of that level,” said the banker. The Nikkei was last at 10,000 at the end of 2012, before the launch of Abenomics.
The index ended July at 20,585. Investors’ appetite for a knock-in at 12,000 – or 60% of 20,000 – is far less than it was at 60% of 10,000, the banker explained.
That is seeing structured product issuers offer more products based on the performance of two indices – such as the Nikkei and Eurostoxx-linked Uridashi.
Avid selling of volatility in Japan and Korea has long seen cheaper downside protection being available in these markets than elsewhere.
“You still see relatively low skews” in Asia, said Hong Kong-based Tobias Hekster, co-CIO of Capital True Partner Advisor, referring to uneven volatility on the down and upside. Those low skews have now spread to Europe, in part because of Asian sales of volatility in Eurostoxx-linked structured products.
The unnamed banker said that “on the whole this year has been very good” for structured product sales.
Hekster sees more investor interest for products which are both long and short volatility – such as the $100 million fund he manages – in the latter part of the year. “We see a lot of interest from the US,” he said, as investors there see an upcoming end to the S&P 500 bull run – which should lead to more volatility.
“I can’t foresee a full-blown crisis,” he said, “but there are enough clouds on the horizon” for things to be more interesting, from an equity market volatility point of view.
His volatility arbitrage fund is up 7.5% so far this year on the back of consistent monthly returns.
“Where our fund runs a spread strategy with both long and short volatility positions, anxiety has shifted from the long to the short legs,” he said.
Until recently, since the global financial crisis, prospective investors had been asking about the “theta burn rate,” Hekster said, referring to the cost of staying invested (in contracts that have an expiry date) when volatility stays flat.
Low equity market volatility sees long contracts (which buy volatility) lose money.
The post-GFC period has been one long period of relatively low volatility punctuated by short-lived spikes.
In the US, the Vix measure of S&P 500 volatility ended last week at 12.1. Even China’s July stock market turmoil saw Vix spike at just 19.9 on July 9 and 15.6 on July 27.
In contrast, Vix was at 58.89 on October 1, 2008 and 42.96 on September 1, 2011.
Similarly, Vstoxx – or Euro Stoxx 50 volatility – was at 54 in September 2011 during the height of the euro crisis, but only 31 on July 8, 2015, and 22 on July 27 this year.
Likewise, the highest level of Hong Kong’s Hang Seng index volatility (VHSI) in the last five years was 54.01 on 12 August 2011. On July 8, the VHSI jumped 58.39% to 38.25. It rose 30.17% to 24.94 on July 27, the day which saw China’s CSI300 index plunge by 8.5%, its largest one-day decline since 2007.