Statistical arbitrage is one hedge fund trading strategy proving to be a functional way to navigate increasingly volatile markets. Current market conditions mean that the strategy, which uses mean reversion analyses to determine investments that are held for a short period of time, can thrive on volatility where other approaches falter.
“Hedge funds — especially uncorrelated strategies such as relative value and discretionary macro — have proven quite resilient during the recent market turmoil,” said Paul Zummo, CEO and CIO of J.P. Morgan Alternative Asset Management Hedge Fund Solutions, in an interview with II. “Especially noteworthy are statistical arbitrage managers that have continued a multi-year run of strong performance. Such strategies are not only neutral to market direction, but often to industry and style risks as well.
“The resulting portfolio tends to benefit from a heightened volatility regime,” Zummo added, “so long as volatility doesn’t increase to extreme levels.”
Investors have long used hedge funds to protect their portfolios in times of stress, but many trimmed or even cut their portfolios in recent years as markets climbed. Now investors are looking at alternatives to diversify. In his most recent investor letter, for example, BlackRock CEO Larry Fink wrote that the traditional 60-40 portfolio of stocks and bonds is no longer fit for purpose, instead suggesting a portfolio mix that includes around 20 percent in hedge funds, real estate and other private market assets.
J.P. Morgan’s stat arb strategies, which typically hold portfolios for no more than six weeks but often for only one week, aim to amplify small inefficiencies that come from high market volatility.
Success of the strategy is determined by the level that the CBOE Volatility Index, the VIX, is sitting at, according to Zummo. When the traditional volatility measure is low then stat arb is less effective and if it is very high, say at 100, there is greater risk of forced deleveraging.
Generally speaking, a VIX above 30 indicates a volatile market, with anything between 15 and 40 signaling ideal conditions for stat arb. As volatility increases so does panic and trading. Sitting at around 33 on Tuesday, the VIX is high but not so high that it has caused problems, a level of around 60.
Discretionary macro and multistrategy models also saw successes in the opening quarter of the year. For multistrats, most have ended the April sell-off slightly higher on the month. A combination of slight de-risking coming into the month, strong risk management, and the absence of forced, structural deleveraging drove the returns.
But Zummo warned that some strategies that have typically done well during stressed markets have not fared as well in the current market environment, including managed futures and bond basis trades. From his perspective most of these losses still could be described as “nicks, scratches, and bruises,” and Zummo was keen to emphasize that “no one is losing a limb.”
