Insurance is the bedrock of the financial system. It has existed since the dawn of ages, dated back to 3rd millennia BC in ancient China. Insurance companies have been selling risk for ages, and yet, we rarely hear about an insurance company going under just because there are more insurance claims. So how come insurance companies know how to sell risk (and sell it systematically), while short volatility funds, who practically do the same thing in financial market, blow up quite frequently?
I’ve always had a sweet spot for these “Epic Failures” stories about volatility strategies gone awfully wrong, as they tend to exhibit the same pattern over and over again. The saying that history doesn’t repeat itself but if often rhymes describes perfectly volatility funds blow-ups. I will take you on a tour through the history of volatility funds epic failures to understand what went wrong, how these strategies blew up in their face, and what lessons are to be learned. So let our journey begin…
LTCM- Too Big To fail
While the failure of Long-Term Capital Management (LTCM) was not tied solely to volatility strategy that went wrong (although it did play some significant part in its collapse), one cannot comprise a list of epic failures without mentioning the colossal collapse of the largest hedge fund at the time, which almost brought down, single handedly, the entire financial market with it.
In 1994 John Meriwether (ex- Salomon Brothers) launched LTCM with $1.3bn AUM, after hiring the smartest traders and mathematicians at that time (including two future Nobel Prize winners, Myron Scholes and Robert C. Merton to be on his board of directors).
The core strategy of LTCM was a continuation of Meriwether’s strategy at Salomon Brothers, which was bond arbitrage, but as the assets of the fund grew, the fund was unable to scale its bond arbitrage strategy. At that point, the fund expanded its portfolio to equity merger arbitrage and equity indices volatility arbitrage (short index volatility in essence) .
During its first three years of existence, LTCM returned on average about 30% on annual terms (after 27% in success fees by the management). Even during the Asian Financial Crisis (AFC) in 1997, LTCM managed to return 17%. So how did it turn so sour in such a short period?
After managing to stir through 1997’s AFC, LTCM felt as if its models were bullet proof, but it took less than a year to prove them wrong. On August 17th, 1998 Russia defaulted on its debt and devalued its currency. That action sent shockwave throughout financial markets, resulting in a spike in volatility. That very rapid move in volatility (and assets’ prices) took LTCM into a spiral of heavy losses. On Aug 21st 1998 they lost $550mm in a single day (15% of the entire fund), and was down 45% by the end of august. On Sep 23rd the Federal Reserve bailed LTCM, as their fall was threatening the entire banking system (ironically that happened almost 10 years to date before the collapse of Lehman Brothers)
To understand how things turned so sour so quickly we first need to understand LTCM model’s assumptions and the fund’s leverage:
- Assets’ prices tend to converge toward their “fair value”. Divergence from fair value cannot last in efficient market. Inherently they assumed human behavior is rational.
- Diversification across different markets (and regions) reduces the risk of the portfolio. Historical correlations don’t tend to break down.
- Historical volatility is a good predictor for future volatility (ironically, the main problem of the Black-Scholes model)
- LTCM was leveraged 1:27, meaning that on its $4.5bn of capital they had obligations of $125bn.
If we focus on LTCM’s short equity index volatility strategy (which lost $1.3bn in total), we can understand how these assumptions and leverage contributed to their huge losses. LTCM basically sold about $50mm vega long dated (2–3y) Variance Swaps on global equity indices (from US equity indices to European and Asian equity indices), as they believed that the implied volatility is extremely rich (they sold volatility around 20% while the realized vol was around 13% on average). They believed that their diversification would reduce the idiosyncratic risk, and they will (on average) gain the VRP (volatility risk premium). As things turned sour, volatility spiked to 35%–40%, and they were unable to unwind their position, as they were too big for the market, so when they started liquidating their positions they exaggerated the move (hence, they were short gamma).
Citadel (2008) — Post Lehman equity derivatives losses
Most of us know Citadel as one of the largest hedge funds in the world (with $32bn AUM) that makes markets across different asset classes, but it wasn’t that long ago when Citadel was actually on a brink of collapse due to positions that had gone terribly wrong.
In the aftermath of Lehman Brothers’ collapse Citadel, which accounted for about 30% of the total volume of US equity options (both indices and single names), took a massive hit with volatility spiking. The volatility spike and market disarray caused the firm to lose 50% of its value by the end of 2008 (Totalling $8bn in clients’ assets). As the firm was on the brink of bankruptcy Ken Griffin (Citadel Founder/CEO) suspended redemption until the fund can stir through the extremely volatile period following Lehman’s bankruptcy.
Citadel, like LTCM, was a very significant supplier of volatility to the equity market, through its short volatility strategies (both via market making and via other equity volatility strategies). The fact that they were the equity market insurance company put them in a very risky position as volatility regime changed quickly through the summer/fall of 2008.
Unlike LTCM, Citadel leverage was significantly lower, which put them in less jeopardy. That said, Citadel had to deny rumors about solvency issues, as the market was fearful that they will have to liquidate their derivatives book and wreak havoc in the already fragile market.
Capstone Asia Fund — Taken down by a tsunami
If there is a story about a volatility strategy that was merely a victim of circumstances it’s the story of Capstone Asia Fund. On March 11th 2011 an earthquake hit Honshu island of Japan, which caused a tsunami. The tsunami hit Fukushima nuclear reactor, which caused the worst nuclear disaster since the Chernobyl disaster in 1986. This was quite unfortunate for Capstone, which had a large Variance Swap relative value strategy between the Nikkei 225 (short) vs. KOSPI200 (long).
That natural disaster, which came out of nowhere (literally), caused the fund 11.2% losses in the month of March 2011, and the shutdown of the firm (eventually).
LJM Preservation and Growth fund- Blame it on the VIX
The story of LJM has very little to do with growth or preservation (despite its name). Since its inception in 2013 , LJM P&G (an affiliate of LJM Partners) was a mutual fund that ran volatility arbitrage strategies in S&P500. In its SEC filling on Feb 28th 2017 the fund stated in its Principal Investment Strategy that “The Fund aims to preserve capital, particularly in down markets (including major market drawdowns), through using put option spreads as a form of mitigation risk” (link to the SEC filling in the appendix). On Feb 5th 2018, during the VIX spike (aka, Volmageddon) the fund lost over 50% of its value, and another 60% of the remaining value over the next week as the fund was forced to liquidate its positions at unfavorable prices. In total the fund lost nearly $800mm of its investors money. Another troubling side of LJM story is the lack of transparency by the fund. The fund did not disclose the full scope of its strategy to its investors (unlike ETNs, that state their strategies), and did not disclose the sheer drop of its assets on Feb 5th, and only did so at the close of business the following day.
Later in 2018, LJM Partner dissolved the fund, and is currently in the midst of a class action against unnamed ‘manipulators’ it blames for manipulating VIX prices using option prices on the S&P500 (as well as Well Fargo, its broker, for forcing the fund to liquidate at a “disadvantageous time”).
Most people know the story of OptionSellers.com because of the viral YouTube video of James Corider apologizing to his investors for the fund’s losses ($150mm in total), but it’s important to understand the full scope of the story behind that video to understand the risk of naked option selling and poorly diversified portfolio.
OptionSellers.com was a Florida-based hedge fund which specialized (and the name implies) in selling options. Their only two holdings were short options in Natural Gas, and short options in WTI Crude Oil. During the first two weeks of Nov 2018 Natural Gas futures moved a whopping 50% (with short term realized volatility around 120%), and WTI futures dropped 15% (with short term realized volatility around 50%).
The massive move in both positions generated for the fund a huge loss, which essentially brought it to its knees in three days, as the fund was forced to liquidate its positions with no cash left. If that wasn’t enough, clients had to pay the fund’s brokerage firm $35mm to settle the losses of the fund.
OptionSellers.com was not the first casualty of Natural Gas volatility. On Sep 2006 Amaranth Advisors was forced to liquidate the fund, which resulted in a loss of over $6.6bn in, what was then, the largest hedge fund blow up. A large portion of the fund’s loss was tied to option calendar spreads (in a very volatile market) which went significantly against the fund’s strategy.
Amaranth was just too big for the Natural Gas market, so it could not unwind its huge position without causing a gamma/delta squeeze (which caused further losses as they had zero to no liquidity, and the rest of the market participants knew it).
March 2020 — A handful of blow-ups
The year 2020 will probably be considered as a critical juncture in volatility investing, as it emphasized the risks and pitfalls of short volatility strategies. Between the largest four volatility funds blow-ups in March investors lost over $7bn . Let’s look at the most infamous funds that went up in flames during March’s volatility spike:
Allianz Structured Alpha
Allianz Structured Alpha managed to lose over $3bn in less than 2-weeks during the market downturn in March as a result of vague volatility strategy that went very wrong. Despite the fund’s investment philosophy, which stated that the fund is “Long and short volatility at the same time, at all time”
Following the massive loss, Allianz liquidated two funds, and is now in a legal battle with its investors (including the MTA pension fund, Arkansas Teacher Retirement System, and Blue Cross Blue Shield fund), which are suing Allianz for over $4bn.
Malachite Capital Management
Until it blew up, Malachite was the poster child of short volatility funds. Founded by two Ex-Goldman Sachs equity derivatives traders. Since its inception in 2013 the fund returned double-digit annual returns (22% and 21% in 2016 and 2017, respectively). Their strategy of collecting premiums for leveraged short low delta puts on S&P500 via Variance Swap cap selling (call options on variance swaps) was very profitable as the realized volatility was extremely compressed, and VRP was high, but as volatility started to pick up (and as a result of a very convex risk of variance swap), the fund was forced to shut down after its $1.5bn bet turned very sour in a very short time.
Parplus Partners/Ronin Capital
When Jim Carney founded Parplus Partners in 2017 he bragged about not charging management fees, as the fund “Eats what it kills”. Fast Forward 3-years, the fund’s volatility strategy, which was “Designed to protect investors in down market” (according to the fund’s investment philosophy), went up in flames, as volatility sky-rocketed, and they were unable to meet their margin call. The fund’s strategy was involved with a synthetic forward variance spread (using VIX options vs SPX options).
Not only that Parplus shutdown the fund, but also caused its largest investor, Chicago-based Ronin Capital, to shutdown the fund (after failed to post margin, CME auctioned Ronin’s futures portfolio).
Ironically enough, Carney was quoted in interview on Nov 20th 2019 saying that “It does seem to be a good bet that at some point the VIX will jump”. He probably should have listened to his own advice.
The Alberta Investment Management Corp. (AIMCo) lost about $3bn on a wrong-way volatility strategy, that simply blew up when markets crashed in March. If the losses in the short volatility program were not enough, they were exacerbated by AIMCo’s “portable alpha” strategy that overlaid the volatility program.
Based on these epic failure stories (and this is barely the tip of the iceberg when it comes to vol strategies that blew up), one would think that selling volatility is a losing strategy. I would argue that short volatility is a profitable strategy, IF DONE RIGHT.
Every failure story here had one (or more) critical error (embedded in the strategy or risk management):
- Understanding the risk-reward profile of your instrument — There is a huge difference between trading ATM options, deep OTM options, VIX futures, or VIX options. Each instrument has significantly different risk profile (including vol-convexity/skew), failure to understand the 2nd order Greeks is a crucial error, which, in a significant downturn, generate huge losses.
- Portfolio diversification — When constructing any portfolio a sufficient diversification is essential to reduce specific risk. That is true also when constructing a volatility portfolio. Obviously in a severe downturn correlation tends to go to 1, but in cases like OptionSellers.com and Amaranth even a modest diversification of the portfolio would have reduced the likelihood of blow-up.
- Run a very conservative risk management — As volatility strategies tend to be rather explosive in scenarios of risk-off, one should assume a very negative spot-vol correlation (i.e. volatility skew) when running scenario/stress analysis on the portfolio level. We should never assume realized volatility to persist (as LTCM did). The portfolio should be analyzed under different volatility regimes.
- Understand leverage — Derivatives are leveraged products, so using additional leverage should be done carefully. As we pay little to no attention to our leverage when markets are calm and going our way, a downturn can turn our portfolio to a timebomb waiting to go off.. Position sizing is crucial in avoiding margin calls and forced liquidation.
- Find a cheap hedge to protect outsized moves — The purpose of a cheap portfolio hedge is not to gain long tail exposure, but rather reduce the risk of catastrophic failure of the volatility strategy. A good hedge should be one that is rolled systematically with minimum P&L bleeding. When looking for such a hedge one should not look at the correlation, but rather conditional correlation (given a very adverse move of the underlying position).
If we look at the chronological order of these blow-ups we can see an interesting pattern which arises. Almost all of these funds (excluding Capstone) failed within 2 years prior to the end of the growth cycle. LTCM blew up prior to the burst of the dot.com bubble, Amaranth and Citadel prior and post Lehman and the housing bubble, and the blow-ups since 2018 happened prior to the abrupt end of the recent growth cycle. This pattern raises some questions whether fund managers, who run short volatility strategies, take into account the stage of the economic cycle of which they are in. This is rather intuitive, as these strategies perform extremely well in periods of growth and relatively calm markets (as do strategies of Call overwriting), but as we near end of economic cycle, the VRP compresses, and shorting implied volatility become extremely dangerous.
As the world of volatility trading attracts more participants, it’s only right to assume that funds and strategies will continue to make the same mistakes that other funds did that put them out of business, mostly because of the high risk-reward of these strategies. Hopefully anyone who wants to be in the game for the long run will make an educated decision to “leave some chips on the table”, and run a sufficient risk mitigation overlay on the strategy to avoid a colossal failure like we have seen above.
Feel free to share your thoughts and comments.
Twitter: Harel Jacobson