Some investors believe the central banks’ inflation fight will lead to a ‘hard landing’, as higher interest rates strangle growth and cause recessions. Others believe that policymakers will succeed in bringing inflation under control without stalling the economy.

Implied volatility

This uncertainty can be observed directly in financial markets by looking at the cost of buying insurance on specific assets using options. Options give investors the right, but not the obligation, to buy or sell a specific asset at a pre-specified price.

The cost of protection on interest rates has remained elevated in recent quarters as inflation and central bank monetary policy have become harder to forecast (see Chart 1).

Equity implied volatility, however, remains low. Implied volatility, which affects options pricing, reflects the range of possible outcomes for a security and the magnitude of daily price swings that investors can expect.

We think both the US and Europe are likely to experience recessions next year. The heightened volatility in interest rates will eventually feed through to other asset classes, such as equities, in the coming quarters.

Source: abrdn, October 2023

Where are the opportunities?

When markets are volatile this can create pricing discrepancies between related instruments that hedge fund strategies can profit from.

For example, in the US Treasury market, there are cash bonds that are issued by the government and purchased by investors, but there are also derivatives – futures contracts – that are widely used by speculators and people who want to buy protection to manage their interest-rate risk.

Ultimately, the bonds and the futures contracts are connected – upon maturity the owner of the futures contract will be delivered a government bond as settlement at the agreed price.

But in the short term, during fast-moving markets with high trading volumes, the cash market and the derivatives market can become dislocated.

Relative value strategy

A hedge fund can profit when two related asset classes move out of sync by employing a ‘relative value’ strategy – buying the cash bond and selling the futures contract (or vice versa) to capture the price difference between the two instruments (see Chart 2).

An uncertain environment in which interest rates are volatile and where the government is issuing a large amount of new debt, typically throws up a lot of these types of opportunities.

Source: abrdn, October 2023

Even more strategies…

Higher market volatility can also benefit a range of other alternative hedge fund strategies (see Chart 3). For example, discretionary and systematic macro strategies have the flexibility to trade across different asset classes, depending on where opportunities emerge.

There are funds that specialise in trading the implied volatility itself, which is expressed via options pricing. These funds are captured by the HFRI 500 Relative Value Volatility Index.

Some fixed income instruments, such as mortgages, can also benefit from higher volatility as elevated uncertainty around the path of future interest rates leads to an increase in the yields earned on assets such as mortgage-backed securities (MBS).

Mortgages have embedded options as they allow the borrower to repay the loan ahead of maturity should interest rates fall. As interest-rate volatility increases, so does the value of the embedded option that MBS holders are selling to the mortgage borrower, resulting in an additional yield premium investors can earn without needing to take on additional credit risk.

Source: HFR, MSCI, Bloomberg, USD, 30 September 2023. The HFRI 500 Investable Index (“HFRI 500”), a broad-based investable hedge fund composite index, comprised of several sub-strategy indices and in total allocating up to 500 funds. Indexes are unmanaged and have been provided for comparison purposes only. While the index is net of underlying manager fees, no fund-level fees or expenses are reflected. You cannot invest directly in an index. The performance above is not intended to be representative of the performance of any abrdn products or services. VIX Index determines volatility regimes with a threshold set at 20.

Last thoughts

In an increasingly unpredictable world, we are focusing on those areas within the Alternative Solutions universe where uncertainty and volatility are not threats, but sources of potential opportunity and returns.

The flexibility that our mandate gives us allows us to deploy a series of more sophisticated investment strategies that are off the beaten track.

We can also consider newer types of investments, such as digital assets, which we think deserve closer attention as regulators around the world work to integrate them into legal frameworks.

As they become more mainstream, we expect more institutional investors to take notice, especially as new technologies, such as distributed ledger technology, shift investor focus away from speculative interest.

We head into 2024 not confident that we can predict the future. But we are confident that we can continue to generate returns through the many twists and turns that will inevitably come our way.