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Crisis Alpha & Why Volatility Is The 'Only' Asset Class

Excerpted from Artemis Capital Management letter to investors,

There is a tiresome debate as to whether or not volatility is an asset class. Let me end that debate... Volatility is the ONLY asset class. We are all volatility traders and the only question is whether we realize it or not.  If you disagree do me a favor and imagine you are an alien that just landed on earth and you know nothing about investing. Stocks, bonds, what are those? All you have to look at are numbers.

Most investments will show upward growth in a steady and seductive line until they experience horrific drawdowns: classic value investing, credit, real estate, and carry trades all fit this profile and are akin to shorting volatility, correlation, and dispersion. Other investments exhibit negative to flat returns with huge profit jumps that occur infrequently. Examples include global macro funds, trend-following CTAs, and tail-risk funds.

Most of what we think of as alpha is actually short volatility in sheep’s clothing. To prove this point we took a cross section of popular hedge fund strategies and compared their returns against selling naked put options on the S&P 500 index. The results speak for themselves and the average hedge fund strongly resembles a simple short volatility position.

I find it puzzling why institutions focus on superficial asset buckets but fail to categorize investments by what really matters... return profile. This is akin to categorizing a blue and green parakeet as two entirely different species of animal, but putting an alligator and the green parakeet in the same bucket. Diversification is futile if you do not categorize by return style.

Many investors assemble a varied portfolio of asset classes and hedge funds thinking there is safety in diversification... but all that is achieved is concentrated short convexity exposure. In a crisis the portfolio is revealed for what it really is – majority short volatility with no diversification at all.

Very few investments maintain a dedicated long convexity return profile. It can be hard to hang out with the designated driver when everyone else is getting drunk from the global monetary punchbowl. Many great investors understand that having a convex asset in their portfolio allows them to buy when everyone else is selling, stick with their investment plan in times of duress, or even apply a bit of leverage onto their beta to pay for any negative carry in the low turbulence years.

It takes a very special breed of investor to allocate to a long volatility fund and be able to tolerate years of neutral performance to small losses when everything else is going up in value... only to achieve remarkable gains when everything else crashes and burns. The key is to view a portfolio holistically, understanding that long volatility exposure provides tremendous flexibility and better risk adjusted returns over the entire business cycle. The two classifications of positive convexity hedge funds are long volatility funds and tail risk funds. While long volatility and tail risk both provide exposure to crisis, they represent very different vintages.


CBOE/Eurekahedge publishes indices that track the respective performance of each style.


They say that being short volatility is like picking up pennies in front of a steamroller. If I had a penny every time somebody mischaracterized Artemis as a tail risk fund I could probably buy a steamroller.

Long volatility hedge funds are in search of crisis alpha defined as an uncorrelated return stream whereby the balance of risk and reward is skewed toward systemic crisis in markets without the constant negative carry associated with traditional hedging. This vintage of convexity should have a positive risk-to-reward ratio overall but with the best gains reserved for market crashes. To achieve this end such funds may balance long volatility exposure with strategic shorts or use tactical exposure to gain convexity. These funds are better at capturing regime shifts in volatility associated with bear markets as opposed to one off volatility spikes that mean revert in a bull market. That nuance is lost on many investors. Long volatility funds are designed to capture market endogenous forms of crisis (e.g. 2008 financial crash, 2011 debt ceiling crash) but may or may not capture market exogenous crises (e.g. market sell-off from 9/11 terror attack).

Tail risk hedge funds are effectively a form of financial asset insurance that provides constant exposure to long convexity, with strong reactivity to crisis, but constant negative bleed.  The tail risk fund has a negative expected return (absent a combination with equity beta) and is more of a pure hedge, as opposed to the long volatility fund, which is an alpha strategy that behaves like a hedge. Tail risk funds are positively exposed to both market endogenous and exogenous events, and do a better job capturing one-off volatility spikes. The CBOE tail risk index brings much needed transparency to tail risk funds, some of whom prefer to remain opaque to the disadvantage of investors. For example, one provider that is not a member of the index, reported recent returns to the financial media on a margin basis (effectively doubling or quadrupling returns) while reportedly excluding the fact that a portion of that performance was generated by buying equity futures the morning of a volatility spike. In actuality, this fund’s performance was in line or likely below the CBOE tail risk hedge fund index on an equal comparison basis (non-margined). All the funds in the tail risk and long volatility indices have agreed to a level of performance transparency and fairness to the benefit of investors.  

Long volatility and tail risk funds can be combined with basic equity exposure to create fantastic returns. A 50/50 combination of the CBOE long volatility hedge fund index and the S&P 500 index has significantly outperformed the market and the HFRX global hedge fund index since 2008 (see above).

In many cases, institutions can layer the convex derivatives exposure directly on the equity beta so there is no lost opportunity cost. The difference is that investors are only paying for ‘crisis alpha’ and not generic beta or short convexity exposure.

The best long volatility funds are like guerilla freedom fighters as opposed to a standing army. Small is better than large for long volatility because convexity does not scale as easily as fragility. Long volatility is a tough business model which is why it is so rare to find funds that offer true exposure. It is simple human nature to lose interest in an asset that has flat returns for years at a time with huge payouts only occasionally. Plain vanilla short convexity funds that make steady returns are a much easier sell and accrue incentive fees faster until they blow up.

Somebody once said that he thought there would be a $10+ billion volatility fund one day... that may be true… but at that point, it may cease to be a true volatility fund and risks becoming just an average hedge fund. Small is beautiful. Hedgehogs outlasted dinosaurs.

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The complete Artemis Capital letter to investors is below: