Can Hedge Fund Managers Master Market Volatility?

Volatile markets are the new normal. But while some thrill-seeking hedge fund managers are enjoying the wild ride, others can't wait for it to end.

Since the Arab Spring turned into the Euro Summer, the capital markets have been on a roller coaster ride that has Wall Street veterans scratching their heads, investors heading for safer ground and risk-loving hedge fund managers eager for another ride. Many investors may panic at signs of volatility, but for today's high-speed trader, there is real upside in this market.

"There's always opportunity," according to Michael Levas, chief investment officer for Olympian Capital Management, a Fort Lauderdale, Fla.-based hedge fund, who says it all depends on the scope and depth of the fund managers' experience. "Whether they are long or short; whether they are global macro -- how they perform will depend on their whole framework and strategy," he asserts. "We have longs that are making money. Do we have shorts that are making money? Yes."

The volatility is stunning. Although the market was up overall for the year, starting in summer 2011 trading days began to see freefalls of 1 and 2 percent, with equally large climbs the next day. The dips typically followed bad news from Europe and gridlock in Washington, D.C., which is expected. But there have been days when the stock markets seemed to rally for no apparent reason. And when genuine, positive news does buoy the markets, the jumps look almost panicky in nature. (Look no further than the last day of November 2011, when the NYSE leapt 400 points, or 4.2 percent, on news that the Fed had flooded European banks with much needed money.)

The impact from Europe is being felt around the globe. According to Anthony Michael, who manages fixed income for the Asia Pacific region for Aberdeen Asset Management Asia, "It's a rough ride right now," even in Asia. He adds, "Since July and August, when Greece started to fall apart, the equity selloff began, and it started blowing out in September."

Sitting On the Sidelines

Despite the bluster exhibited by Olympian Capital's Levas, some hedge fund managers are leaving equities to wait for the storm from Europe to blow over. As a result, according to experts, the recent market volatility has been coupled with another vexing factor: a lack of liquidity.

"If you look at the recent volatility, there has been a lack of liquidity in the marketplace," says Simmy Grewal, a London-based analyst with Aite Group. "That could be because a lot of people are sitting on the sidelines, in the equity markets for the most parts."

Grewal adds that the European markets have seen low liquidity levels since the market meltdown in 2008. "Volumes have dropped off drastically and we haven't seen any massive recoveries in liquidity," she says. "I can understand traditional asset managers looking at other asset classes, the sort of low-risk instruments compared to the equity markets. They are also sitting on cash as they wait for the market to reveal the next place to go."

Right now, Grewal reports, there is more movement by traditional asset managers into other assets classes, namely fixed income, foreign exchange (FX) and credit derivatives. Hedge funds with more sophisticated arbitrage strategies, however, can take advantage of the volatility in the markets as the more traditional buy-side firms sit on the sidelines, she suggests.

According to Aberdeen's Michael, fixed income in overseas markets has been a recent safe harbor for fund managers -- provided the firms are based in the region and don't have to deal with the volatile exchange rate. "It depends on what part of the fixed-income space you're in," he says. "The currency rates have hurt people in the last couple of months. If you live in Asia and you invest in your own bond markets, you get returns of 3 to 4 percent and even 5 to 8 percent. If you're offshore, the currency volatility kicks in and it hasn't been so fabulous."

In a sign of the volatile times, even after Standard & Poor's lowered the credit rating of the United States in late summer, global investors rushed in to scoop up U.S. government bonds in reaction to another day of bad headlines from Brussels. "We have a saying at the moment that AA is the new AAA," notes Michael.

Will the Market Volatility Ever End?

While the trading swells and swoons were particularly pronounced in late summer, many market experts believe the volatility is an ongoing ripple effect from the 2008 credit crisis and the collapses of Bear Stearns and Lehman Brothers. "The last six months have been extremely volatile in the markets in general and around the globe," says Boryana Racheva-Iotova, president of risk management solution provider FinAnalytica. "But most of the last three years the markets have been volatile compared with what we've been used to. It's much more volatile at a faster rate in a shorter period," she argues, adding that "this is the new normal."

According to Aberdeen Asset Management's Michael, all eyes are on Europe, and the recent wave of volatility will last into next year. "For the next six months, there is going to be a lot of uncertainty about Europe, no matter what they do or say this week. There is going to be months of uncertainty in the market," he insists.

"Asian currencies will still struggle against the U.S. dollar for the next six months," Michael continues. "But once the volatility recedes," he predicts, "a basket of Asian currencies will perform pretty well against the U.S. dollar over the next 12 to 18 months."

If the politicians and regulators get their acts together, however, might the wave of wild volatility level off? Probably not, suggests FinAnalytica CEO David Merrill, who compares the situation to the game of Whack-a-Mole. "Right now, the politicians potentially could be stronger and do a better job, but there are a lot of issues," he says. "When one issue is addressed, people move on to the next one. We should expect that this instance of heightened volatility will be pretty persistent."

So, should investors and hedge fund managers be spooked by the recent, unpredictable market volatility? Not in the least, says Olympian Capital Management's Levas. "I'm not spooked at all by it," he says. "We're professionals -- we're supposed to take what the market gives us, and that's what we're doing."

Phil Albinus is the former editor-in-chief of Advanced Trading. He has nearly two decades of journalism experience and has been covering financial technology and regulation for nine years. Before joining Advanced Trading, he served as editor of Waters, a monthly trade journal ... View Full Bio