If there is a "Holy Grail" in investing, it is the desire to find assets that do not move in the same direction. But in reality, supposedly uncorrelated assets can act alike in times of market stress. Barclays Capital thinks it may have an answer. Has it?

If there is a “Holy Grail” in investing, it is the desire to find assets that do not move in the same direction – or in other words, investment returns that have low, or negative correlations. The whole point about having a diversified portfolio hinges on this notion.

But as the 2008 financial panic taught us, many of the supposedly low or negative correlations that feature in the marketing literature for hedge funds, commodities or other “alternatives” often fail to work in practice. In fact, as the turmoil of that year demonstrated, when fear grips markets, pretty much all assets can move in the same way. Standard models of risk distribution get trashed. I remember how, for instance, gold prices fell more or less in lockstep with equities during a period of financial alarm. Obviously, the gold market did not get the memo that gold is supposed to be a hedge. Over longer term periods, of course, correlations may indeed hold good, but that is scant comfort if your portfolio has taken a hammering in the short run and you are about to retire.

Mindful of such issues, Barclays Capital – the investment banking arm of Barclays and sister business to Barclays Wealth – has hit on the idea of making it easier for investors to trade in volatility as a strategy in its own right. When markets are turbulent – and often falling – any investor who is “long” of implied volatility, as can be done through the listed options market, can make money. For those looking for negatively correlated assets, it seems like the real McCoy. (Implied volatility is what markets expect the realised volatility of a market to be, based on option prices).

Some measures, or “fear gauges” of market risk have been around for a while now. The US-based VIX Index, for example, shows the level of investor worry about the S&P 500 index of equities. In times of calm and positive business news, the index has been low, but when developments turn nasty, it can spike sharply. So if investors can be “long” of this index (ie, profit from its rise), this can offset any losses made in the underlying market. It seems like a winner.

In a briefing to journalists a few days ago, Natasha Jhunjhunwala, vice president in the equity and funds structured markets origination team at BarCap, highlighted what she said is the merit of getting exposure to implied equity market volatility via exchange-based notes (ETNs) marketed under BarCap’s iPath brand. These notes, which are debt securities issued by Barclays, pay a return based on short and medium-term performance, via futures contracts, of indices such as the US VIX Index. Barcap also has ETNs which mimic returns from the EuroSTOXX 50 index, which like the VIX tracks implied volatility among blue-chip European stocks. Other banks providing similar products are Citigroup, Credit Suisse and Bank of America.

“For it [volatility] to be treated as an investment, it gives you something that no other asset can give you in that it does well in times of stress. It has a strong negative correlation [to the broader market], which is 90 per cent of the story,” said Jhunjhunwala.

The chart evidence going back to 1999 that was provided to journalists by BarCap is certainly persuasive. The VSTOXX Index – a measure of market volatility in Europe – spiked hugely in the autumn of 2008 when the credit crisis was at its height, and spiked again around the time of the Greek debt fiasco in 2010. In other words, the investor can invest in the “silver lining” of a market “cloud”.

Of course, buying funds that track volatility in this way is not costless; in a flat market, for instance, investors will be paying an annual fee (89 basis points in the case of one BarCap ETN), which may not seem like a good bargain. For long term, “buy-and-hold” investors willing to ride out volatility over a decade or so, it may not make a lot of sense to hedge volatility in this way. And as Barclays Capital points out, buying an ETN is not risk-free: an investor’s principal is not protected and there is no guaranteed secondary market for them, at least not yet.

Trading such volatility has come a long way over the past 40 years or so when the market for listed options got going after the formula for pricing options was developed by Fischer Black and Myron Scholes in 1973. At the time, the market was dominated by professionals; in the 1990s, trading expanded through what are called variance swaps, which are over-the-counter derivatives allowing a person to speculate on or hedge risks associated with volatility of some underlying product, like a stock index. However, OTC markets have their disadvantages – they are off-limits to retail, private investors, given the high capital requirements typically involved. The development of indices, however, has brought with it user-friendly, retail products of the sort developed by iPath, as well as some of Barclays's peers, as mentioned above.

The pursuit of negatively correlated assets continues. But as the experience of hedge funds teaches us, it pays to take any promises with a pinch of salt. Remember, that hedge funds waxed in the early noughties when their ability to make positive returns contrasted with the crash after the dotcom boom. (In 2001, hedge funds on average made returns of 4.62 per cent, according to Hedge Fund Research). But in 2008, hedge funds fell 19.3 per cent, although major equity benchmarks fared worse. Trading volatility is a complex business and holds traps for the unwary. Even so, hats off to those much-maligned financial “rocket scientists” for continuing their hunt for an investor’s Holy Grail.