Capstone Bases Bets on Volatility – Barron's

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The world’s a volatile place these days, and global markets reflect that. In just two instances, investors were blindsided by the devaluation of the Chinese yuan a year ago and, more recently, by the sudden declines of the British pound and Euro Stoxx index after the United Kingdom voted for Brexit. Exacerbating the moves is the fact that the world’s biggest banks have reduced their financial commitment to the markets in order to meet new risk guidelines from regulators.

“Over the course of the coming years, the market is going to get more volatile,” says Paul Britton, the British founder of the Capstone Volatility Master fund in New York. Britton’s fund has an unusual alternative strategy that seeks to profit from volatility spikes. The fund uses its $2.2 billion in assets to buy and sell options on all asset classes, which are contracts with traders that allow—but do not oblige—them to buy or sell the underlying stocks, bonds, currencies, commodities, or even indexes when they reach the prices that a trader wants to buy or sell them for. Britton owns just a few underlying securities—and then, only for hedging purposes. He doesn’t make “directional” bets.

That’s what makes volatility interesting as an alternative asset class. Investors hold options on stocks, bonds, currencies, or commodities and benefit from sharp breaks in their prices. The more prices bounce around, the better for the investor. The downside is that when the markets recover—as stocks and bonds have done since Brexit—volatility shrinks. So the CBOE Volatility Index, or VIX (see chart), a measure of expected near-term volatility as expressed by option prices for the Standard & Poor’s 500 index (SPX), fell to a low of 12.64 on Aug. 16—just over half of the 21.17 level it reached on June 22 with the Brexit vote, and a little less than a third of the 40.74 level to which it rose on Aug. 24 of last year, after the yuan was devalued.

Buying and selling volatility is usually an institutional strategy that taps a very small part of a portfolio and acts as a kind of protection for investors to manage risk. Traders and fund managers use exchange-traded funds and notes like the iPath S&P 500 VIX Short-Term Futures VXX 0.3889969435954432% Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN U.S.: NYSE Arca 36.13 0.14 0.3889969435954432% /Date(1471640400072-0500)/ Volume (Delayed 15m) : 26027428 AFTER HOURS 36.2 0.07 0.19374481040686412% Volume (Delayed 15m) : 930470 P/E Ratio N/A Market Cap N/A Dividend Yield N/A Rev. per Employee N/A More quote details and news » ETN (ticker: VXX) for short-term arbitrage during spikes in volatility, but they’re not intended as long-term holdings, says Tayfun Icten, an analyst at Morningstar in Chicago.

However, the insights of a volatility veteran like Britton can be helpful to investors of all kinds, particularly as geopolitical events—ranging from terrorist attacks to bitter and sometimes violent political battles—increasingly rattle the world’s markets.

Britton, 43, is one of just a handful of former options traders who have successfully reinvented themselves as volatility fund managers, says Icten. The six-foot, four-inch Britton, with a degree in finance from London Metropolitan University, started out as a trader for Mako, an options trading company that dispatched him to New York in 2000. Anticipating that options trading would move from open-outcry trading floors to screens, Britton saw asset management as a more lucrative business than trading. So he left Mako in 2004 and launched Capstone Investment Advisors. He initially sold volatility strategies to institutional investors that used them in their stock-and-bond funds. In August 2007, when global stock markets were already churning in the initial throes of the financial crisis, he launched his flagship product, the Capstone Volatility Master fund, which lost just 5.72% in 2008, far less than the S&P 500’s 37%.

SO, WHERE WILL VOLATILITY come from over the rest of the year? Britton sees U.S. voters growing increasingly uncertain over the potential outcome of the U.S. presidential election in November. He expects the British pound to bounce around relative to the dollar as the U.K. negotiates a potentially messy divorce from the European Union. He sees European banks struggling with artificially low interest rates. And he expects investors to crowd into widely held Internet and social-media stocks that are generally seen as safe bets—both long and short—in tumultuous times.

For the past few years, the markets have not been volatile enough for volatility investors to make a lot of money. Capstone was up 2.28% annualized for the three years through June 30, according to Morningstar. The S&P 500 delivered an 11.66% annualized return in that time. But Capstone is gaining traction as volatility rises this year, delivering a 4.55% return from Jan. 1 to June 30, net of fees, beating the S&P 500’s 3.84% gain. On average, volatility strategies haven’t done well, delivering just a 2.42% net return during those six months, according to the fund tracking firm eVestment in Atlanta. Britton declined to discuss performance or specific prices with Barron’s.

Now Britton is making several bold bets based on the trends he has identified. “Everyone is getting fearful and anxious about the U.S. election,” he says. Yet they’ve been driving up prices for options on the S&P 500. “We think that the S&P index volatility is overpriced right now,” he adds. So Britton has bought out-of-the-money puts, or options to sell the index over the time period covering the November election, as an insurance policy ahead of the election.

But the S&P is only one leg of that trade. To hedge his bet, Britton has also bought puts on the Euro Stoxx index, which he believes are underpriced because there is no election uncertainty to speak of in Europe at the moment. If Hillary Clinton is elected, Britton expects anxiety over the U.S. election to subside and prices for S&P options to fall. “There is no way of quantifying the premium that a Trump victory would have over a Clinton victory. We look at the Betfair site, but there is no options market on this kind of instrument,” he says. Separately, he expects prices for Euro Stoxx options to rise as new worries emerge over the U.K.’s disengagement from the EU. “We are long on the Euro Stoxx puts, and we are short on the S&P puts,” he says.

In the process, Britton has created a spread between the S&P and Euro Stoxx. “We will wait for that spread to revert,” says Britton. “And then we’ll be able to make our money.”

In Europe, Britton expects banks to be volatile because they have been accepting deposits with negative interest rates for the past two years in accordance with a European Central Bank policy that has made Europeans uncomfortable. To play this bet, Britton is using “strangles,” which involve buying both out-of-the-money puts and out-of-the-money calls on a single stock. “You are looking for the individual stock to have either a large move down or large move up,” he explains. He would not identify specific banks.

In a currency play, Britton is betting that volatility will rise in the U.K. over Brexit. “Where there is uncertainty, there is typically volatility,” he says. He is buying put options on the British pound that will be in the money when the pound, which was trading at $1.31 on Aug. 18, weakens to $1.25. “Then we would expect to see a heightened level of volatility if it breaks $1.25,” he says.

As volatility rises, Britton expects hedge investors to crowd into widely held Internet and social-media stocks like Alphabet GOOGL -0.3861725319215198% Alphabet Inc. Cl A U.S.: Nasdaq USD799.65 -3.1 -0.3861725319215198% /Date(1471640400357-0500)/ Volume (Delayed 15m) : 1087060 AFTER HOURS USD799.97 0.32 0.040017507659601076% Volume (Delayed 15m) : 33703 P/E Ratio 30.97941678967004 Market Cap 541329096794.096 Dividend Yield N/A Rev. per Employee 1314070 More quote details and news » (formerly Google; GOOGL), Amazon.com AMZN -0.935300735159459% Amazon.com Inc. U.S.: Nasdaq USD757.31 -7.15 -0.935300735159459% /Date(1471640400209-0500)/ Volume (Delayed 15m) : 2305752 AFTER HOURS USD756.85 -0.46 -0.060741308050864244% Volume (Delayed 15m) : 37485 P/E Ratio 188.65306529158258 Market Cap 359020983665.286 Dividend Yield N/A Rev. per Employee 522691 More quote details and news » (AMZN), Apple AAPL 0.2566923359002567% Apple Inc. U.S.: Nasdaq USD109.36 0.28 0.2566923359002567% /Date(1471640400359-0500)/ Volume (Delayed 15m) : 24707957 AFTER HOURS USD109.42 0.06 0.0548646671543526% Volume (Delayed 15m) : 660085 P/E Ratio 12.77570093457944 Market Cap 589280115671.657 Dividend Yield 2.0848573518653986% Rev. per Employee 1990500 More quote details and news » (AAPL), Facebook FB -0.2824630780405133% Facebook Inc. Cl A U.S.: Nasdaq USD123.56 -0.35 -0.2824630780405133% /Date(1471640400439-0500)/ Volume (Delayed 15m) : 11491424 AFTER HOURS USD123.54 -0.02 -0.01618646811265782% Volume (Delayed 15m) : 196841 P/E Ratio 59.40384615384615 Market Cap 354735685100.198 Dividend Yield N/A Rev. per Employee 1746120 More quote details and news » (FB), and Netflix NFLX -0.30158069883527455% Netflix Inc. U.S.: Nasdaq USD95.87 -0.29 -0.30158069883527455% /Date(1471640400296-0500)/ Volume (Delayed 15m) : 6904597 AFTER HOURS USD95.82 -0.05 -0.05215395848544904% Volume (Delayed 15m) : 38295 P/E Ratio 299.59375 Market Cap 41101867512.6724 Dividend Yield N/A Rev. per Employee 2060710 More quote details and news » (NFLX), which offer liquidity. In response, Capstone might try to be long Netflix’s six-month volatility and short on Amazon’s six-month volatility. This trade would take advantage of a lack of Amazon realized volatility over the past six months and only a small downtick in longer-dated Netflix implied volatility.

But the markets can move too fast even for Britton and his high-tech trading operation at 7 World Trade Center to anticipate. On July 29, the Bank of Japan announced that it would intervene in Japan’s stock market and buy ETFs. “This is going to dampen volatility,” Britton says. It could also hurt his play on Japan—downside puts in the Nikkei index. Before the announcement, Britton admits, he had expected investors to lose faith in the BOJ’s longstanding efforts to calm the market by keeping interest rates ultralow, which he had expected to increase volatility.

In the months ahead, Britton will wait for his other bets to pay off. “That is a great opportunity for hedge funds that are positioning themselves to replace the risk capital that the banks were once able to keep on their balance sheets,” he says. As investors start to see volatility as a tangible asset class like equity or fixed income, they are likely to become more active in the options market—and in the volatility funds that invest in it. 

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