Championing volatility as an asset class

13 August 2007

Jeremy Beckwith, chief investment officer at Kleinwort Benson, talks to Frances Hughes.

Q: The Gresham Deva Alpha 80 fund was launched in September 2006 and was the only UK regulated onshore fund to use volatility as an asset class. Is this still the case?

A: I think ABN Amro launched one in February. But I haven't heard much about it.

Q: You have stated this strategy is quite a new concept? Why had it not been made available to the British retail market before?

A: [Because] We have been able to use the Ucits III rules. [We are] using a swap to get exposure to a volatility strategy. What the fund owns is 20 to 30 non-dividend-paying US equities and a swap. [The fund] swaps the performance of those equities for the performance of the arbitrage strategy. Before Ucits III you couldn't use that kind of swap.

Q: Before the fund launched, volatility strategies were an institutional-only activity in Britain. How long had it been in the institutional market and how do you use volatility to generate returns?

A: About a year before we launched this fund. Essentially this fund is an arbitrage between the expected volatility and actual volatility of the S&P 500. The expected [volatility] can be seen from monitoring the options market. The expected volatility is the key to what options are worth. If options prices are high, expected volatility is high and vice versa.

The actual volatility is something you can only see afterwards. Markets may or may not behave in the way the expectations are set. There is a persistent gap between the level of expected volatility and the realised volatility.

Probably the reason for this gap is that there are very few people allowed, able and willing to be sellers of options. They [the sellers] are mainly investment banks and hedge funds. There are a lot more buyers of options. That would account for a persistent anomaly. There is the arbitrage opportunity.

Q: How does the process work?

A: On a fixed date each month we look at the level of expected volatility [of the S&P 500] and sell that [through a swap] to the investment bank. In a month's time you promise to buy it back from the investment bank at the level of actual volatility.

You [start by taking] the level of the Vix [the volatility index, tracking the S&P 500] and apply a set formula to determine the strike level for the month. In a month's time you either receive money or pay money, depending on the spread [whether or not the actual volatility is higher than the expected volatility indicated by the Vix index]. Back testing shows actual volatility is lower than expected volatility in about 90% of all months.

Q: What does the '80' in the name of the fund refer to?

A: At any one time at least 80% of the fund is held in cash and not exposed to the strategy.

Q: Would you consider launching funds with different cash ratios, for example, an Alpha 60 fund?

A: Yes, but that would be a higher risk version. With higher risk versions, if realised volatility is high you could lose a large amount of money.

Q: There are two other funds in the Gresham Defined Funds platform. What are they and when were they launched?

A: There is the Japan Accellerator fund and the US Accelerator Fund. Both were launched in 2005. They have done well in the fund league tables. For the 12 months to the end March, 2007, the Gresham Japan Accelerator fund was, according to Lipper, the best performing Japanese equity fund in the UK market, out of 310 funds.

Over the same period, the Gresham US Accelerator fund was the second best performing US equity fund in the UK market, out of 523 funds.

Q: What are the main benefits to retail investors of having this type of fund?

A: Diversification, low volatility and an acceptable rate of return [are the main benefits]. Diversification is absolutely key. It is not correlated with any other asset class. In most months it delivers a good, strong return. There is also low volatility. Back testing shows it [volatility] is less than the gilt index.

From the back testing, in most months, the strategy delivers a return of about 1% a month, but occasionally, when volatility spikes then it delivers a more significant loss.

Q: What return does the Deva Alpha 80 fund target?

A: The back testing we did suggested a return of 9% above cash. It is important to note this is a formulaic strategy. That back testing went back to 1990.

Q: How popular has this fund been since you launched it 11 months ago?

A: It was £23m when we launched and now it is just under £80m. We have seen a lot of interest. Several fund of fund managers own it and we have had a lot of interest from other fund of funds.

Q: What are the best market conditions for a fund like this?

A: Any market conditions, except when there is a shock in the market. In nearly all market conditions it works.

Q: So is this the only way the fund can lose money, when the implied volatility is lower than the actual volatility?

A: Yes. When the market panicked in February and actual volatility was far higher than implied volatility, the fund ended up losing money. This has also happened in the past two weeks. At the end of February the Vix index moved from 10 to 20 in five days. At the end of July it went from 15 to 25 in 10 days.

Q: Is the fund on track to achieve the return target of 9% above cash this year?

A: No. It has been a terrible time for this fund. We launched in September and by late February [the price] was 105. Then there were the problems at the end of February, early March, and the price fell back to 99. It then picked up to 102. [But] in the past few weeks it dropped. The current price is 98/99. We have not made any money. That is because of the two dramatic sharp spikes in volatility.

Q: Is investing in volatility an expert-only activity?

A: Volatility is itself extremely volatile, investors who are not close to markets on a minute-by-minute basis, should not be investing in volatility directly. Deva is an arbitrage strategy in volatility. If you look at the history of how the Vix moves the percentage changes in volatility are great.

It can double in just a few days. It is highly volatile. You can buy or sell Vix futures, but your potential for loss is high. It is not for private investors. This arbitrage strategy is designed to deliver much less volatility in returns.

Q: Will other groups launch these funds?

A: I would think so. We have been surprised there has been so few. Ucits III rules allow you to get exposure [to volatility] so I would expect more to come out.

JEREMY BECKWITH joined Kleinwort Benson Private Bank in April 2003 as chief investment officer. He is responsible for the investment process and the performance of the discretionary portfolios. He joined Kleinwort Benson from Merrill Lynch Investment Managers where he was head of EAFE Equities (non-US equities for Americans).