CQS, a $US10 billion hedge fund based in London, also views volatility as an asset class simply because derivatives are a different type of asset to trade than any other. And as far as volatility strategies are concerned, the direction of underlying securities is irrelevant.

The manager recently launched a global volatility fund that takes directional views on volatility, swinging from long positions in major indices as markets perform well to short as they decline. Either directional strategy, CQS believes, is dangerous in isolation. Sometimes the fund will take directional views of the volatilities of individual stocks. In a dispersion trade, it will short the volatility of a major index while going long on the biggest 50 or 60 names in the same index. The Goldmans paper says that variance swaps, where returns are linear not to volatility but to variance (the average of squared deviations from the mean), are “the purest play on the volatility risk premium embedded in option prices” because the payoff is directly linked to the difference between implied and realised variance. Also, since the payout of a variance swap is based upon the square of a standard deviation, they can generate larger returns than volatility swaps, whose payouts are based on standard deviation. The swaps also do not require a hedge against any shift in the relevant ‘delta’: the ratio comparing the change in prices of underlying assets to corresponding derivatives.

Packaging vol into portfolios

What has held many institutions back from investing in volatility, Goldmans says, is a combination of a lack of performance data, limited information about the types and potency of volatility strategies available, and uncertainties about risk management.

Volatility strategies need to be packaged, or “sized”. Goldmans does this by blending a riskless asset, LIBOR, with a short variance swap, to meet desired risk levels. It observes that during a sample period, from January 1996 to September 2007, an S&P 500 short one-month variance swap instrument, designed to have the same monthly standard deviations as the underlying index, outperformed the bourse itself by 31.2 per cent to 9.6 per cent, with a Sharpe ratio of 1.6, four times higher than that of US equities. The strategies also outperformed 12 of the 13 Credit Suisse/Tremont hedge fund indices on a risk-adjusted basis.

An optimal risk-reward balance in a 60/40 equity/bond portfolio could be achieved if 5 per cent of the equity exposure was comprised of short S&P500 variance swaps that carried as much risk as the underlying index, the paper finds. This portfolio beat its predecessor in nine out of the 10 biggest monthly declines in the sample period by an average of 0.3 per cent, and by 1.08 per cent in the sample period overall, with a 0.49 per cent reduction in risk while holding a 0.48 correlation to the index (its annual performance was 9.5 per cent, with a standard deviation of 8.87 per cent).