Taking advantage of market volatility
Mr. Wünschmann, since Donald Trump's election, market uncertainty has been greater than it has been in a long time. How should investors react to this?
Volatility and fluctuations are definitely back, that's for sure. We got used to a low-volatility environment during the two-year bull market, where a stock index might lose 1% and everyone thought: „Wow, that was intense!“ Otherwise, there were mostly positive returns. But there are other phases, and we are in one of those right now. If you invest in stocks, you should have a time horizon of at least 10 to 15 years. In that time window, you can reasonably expect to earn well from the investment.
The S&P 500 fell by 10%, but has since climbed back to the same level as the start of April...
We did see a decline of around 10% in the S&P 500 – but overall, a 10% drop for a stock index is nothing extraordinary.
What are your expectations for how the markets will evolve? Do you expect a calming down over the rest of the year, or should we expect ongoing uncertainty?
We currently assume that the US will remain volatile for the time being. Too many volatility-inducing factors are at play – geopolitical factors, erratic trade policies, tariffs, and the still very high tech valuations in America. In contrast, we look more optimistically toward Europe, especially with the investment push that is likely to take place in Germany. If that is executed well, it should have a significantly positive effect. On the other hand, Germany as an export nation, and Europe as a whole, cannot fully decouple from the US. The phase where Europe performed so well and America was comparatively weak was something special. Predicting what comes next is difficult – nobody has a crystal ball. We don't focus solely on the current market events under a magnifying glass.
You focus on volatility strategies. How do they work, and what are you specifically targeting in this area?
The good thing about such a volatile market phase is that you are not only exposed to the risks, but can take advantage of the opportunities. There are market strategies that tend to benefit from such phases. Traditionally, volatility is traded through options, meaning with derivative instruments – financial instruments whose value is linked to another financial instrument, or derived from another financial instrument, known as the underlying asset. The Black-Scholes model is the most well-known options theory, and they (Fischer Black, Robert Merton, and Myron Scholes) were the first to realise that derivatives, the options, are not necessarily needed.
How does itwork?
You can replicate the derivative by cleverly buying and selling the underlying asset to recreate the payout profile and risk of the option. When replicating the option, it’s not about where the underlying asset ends up at the option's expiration. The cost of replication is primarily determined by how much the underlying asset fluctuates during the option's lifetime. Since the replication is identical to the option, the option's value is also primarily determined by volatility. Therefore, market participants trade their expectations of the future fluctuation range of the underlying asset, which is initially unknown. This is called implied volatility – the expected fluctuation range, which can be derived from the option's price through the replication mechanism.
Are volatility strategies a separate asset class for you?
Yes. If you take this idea a bit further, you can actually conclude that volatility can be considered its own asset class. If you open the lid and take a deeper look, there are very different strategies with very different characteristics. The most obvious distinction is whether you're buying the option or selling it. When you buy an option, you are a buyer of volatility, „long volatility“. Typically, these strategies are used to take risk out of portfolios or out of the underlying asset. On the other hand, there are strategies that sell options. These are „short volatility“ and are used to unlock volatility as a source of return and thus as an asset class. This brings the so-called volatility risk premium into play.
Can you illustrate that?
As a seller of volatility, you essentially put yourself in the same position as a typical, classic insurance company. By selling options, you receive regular premium income. In the event of a claim—meaning if volatility turns out to be higher than expected – the insurer has to cover the damage. However, numerous empirical studies repeatedly show that options are, on average, overpriced. This is especially pronounced with stock index options. Option sellers are compensated like insurance companies for taking on an economic risk – they typically receive more from the premium income than they have to pay out in claims. This reflects the volatility risk premium in the capital markets. The implied volatility in options is, on average, higher than the realised volatility.
Are you more active in the short or long volatility space?
We are active in both. The premium strategy uses volatility as a source of return to generate income for the investor from uncertainty. Efficient long-volatility strategies can improve the risk-return ratio of an investment. Institutional investors, like pension funds, use them to, for example, make stock returns more predictable. When talking about volatility strategies in the retail context, it's usually in the short space, where volatility is understood as a source of return.
Are volatility strategies also interesting for retail investors?
Definitely! The interesting feature of short volatility strategies is that they can serve as a diversification component and provide another source of return alongside traditional sources like stocks and bonds. For the last few years, this has also been possible for retail investors in Germany, allowing them to set up their portfolios more efficiently. More efficiently means that with the inclusion of volatility strategies, the portfolio can either have a higher expected return with the same risk, or achieve the same expected return with less risk. By the way, Warren Buffett also loves the volatility insurance business. He’s known primarily as a successful stock investor, but his investment company also reports an immense increase in premium income, from 40 million in 1970 to 170 billion dollars in 2023 – a nearly five-thousandfold increase!
In the past, investors using volatility strategies have sometimes gotten burned. How do you protect your clients? Does more safety always mean lower returns?
We collect the volatility risk premium in a strictly risk-controlled manner. Here, the insurance analogy fits again, where regular premiums on the income side are balanced against payouts in the event of a claim. For volatility strategies, there are various risk-mitigation strategies for which we allocate a portion of the income. Similar to insurance, we never take on the entire risk but are only liable up to a systemically predetermined damage threshold. For damages above that, our reinsurance steps in. We can also use the well-known VIX index, the so-called fear gauge of the stock market. The VIX index correlates with the stock market and rises sharply when the stock market falls. By buying call options on it, it can also serve as insurance. What is important to us is that these reinsurance and additional insurance components are always statically in place. In risk management, no risks are taken. Our strategy puts income and expenses into an economically sensible ratio – always statically with every sale of an insurance service.
What is your approach at Warburg Invest?
We are convinced that the evolution of premium strategies lies in risk management. Our unique selling point in the German market is mixing the volatility risk premium with a trend risk premium in the fund. It is the next stage in the evolution of risk management. It started with almost unhedged variants, then reinsurance was added, and finally statistically correlated hedging transactions. Now, we are focusing on a combination of risk premiums. Volatility risk premiums and trend risk premiums complement each other and work in different market scenarios.
When do trend risk premiums come into play?
If long-lasting negative trends emerge in the stock market, it creates a scenario that is unfavourable for the volatility risk premium we typically capture. Reinsurance usually hasn't kicked in yet, and the VIX index might not rise much further if it is already at high levels. However, if the market continues to fall, momentum and trend strategies kick in. They form a macro-hedge since they can benefit from both rising and falling markets. They, therefore, form another component of the risk management within the fund. But in general, just like with all other components of our risk management: better to have than need! All hedging components are permanently and statically in place. One also permanently insures his property or household contents against damage – one doesn't just speculate that nothing will happen for the next five years.
At Warburg Invest, you relaunched your Warburg Defensiv Fund not too long ago, correct?
Exactly. The fund itself and some of its share classes have been around for quite a while. But under the new strategy of strictly risk-controlled harvesting of the volatility risk premium, it has now been running for almost two years. In 2024, we had our first full calendar year and were able to outperform our benchmark as well as rank among the top of our peer group. For this, we were honored with the „UCITS Hedge Award“ by The Hedge Fund Journal.
Even in the current market environment – where a single person can navigate the capital markets with their smartphone – our hedging strategies have once again proven to be robust and effective. For investors looking to benefit from market uncertainty, the current environment offers very attractive entry opportunities. The premiums collected are well above average. On May 18, the fund will be renamed „Warburg - Liquid Alternatives“. With this, we are adopting an established term for alternative sources of return and reflecting the fund’s new strategy and evolution in risk management.
Meet the person
Sven Wünschmann is Senior Portfolio Manager for Multi-Asset and Liquid Alternatives Solutions at Warburg Invest KAG. As lead portfolio manager, he is responsible for the Warburg Defensiv Fund (soon to be Warburg Liquid Alternatives). Wünschmann studied business informatics and mathematics and earned the Certificate in Quantitative Finance (CQF) with distinction.