Merrill analysts see volatility bottoming out, but rising trend at least a year away

By Ronda Fears

Nashville, Feb. 1 - Volatility, a closely watched barometer among convertible players, has been dragging along for two to three years now and there still is not much optimism for a rising trend in 2005, a group of Merrill Lynch & Co. analysts said Tuesday.

They do think volatility may be at a bottom, however, and there are interim opportunities for hedge funds to play volatility - particularly in the Asia markets. But the analysts also foresee some contraction in the hedge fund community as the result of an inevitable withdrawal of capital, or liquidity.

Arik Ross, Tony Lee and William Chan in a research report said they see the old VIX volatility index lingering at depressed levels for most of 2005, bottoming out at trough of about 11%, versus the current 13% level, with no meaningful up trend any earlier than fourth quarter.

"In the meantime the market's capacity to absorb shocks will prevail. Any shock which induces a volatility spike will be immediately washed over with risk capital and is therefore unlikely to persist for more than a few weeks. Such spikes can be viewed as selling opportunities," the analysts said.

"Overall, and particularly in the Asian markets which have a strong tendency to trend, the present time is a great opportunity to start strategically buying long-term options, both at the index and single-stock level."

Presently, the analysts said they see a great opportunity to strategically buy long-term options. There are also potential short-term opportunities. There are two trading strategies, they said: Buy long-dated volatility (2 years and longer) and/or sell short-dated volatility (less than 6 months) on spikes.

Liquidity tap is running dry

Volatility can be thought of as a yield paid to investors for providing insurance, or risk capital, to the stock market - analogous to bond yields that fall when there is a plentiful supply. Both are merely manifestations of liquidity, by way of risk capital, available in the market.

The liquidity tap was wide open in the wake of Sept. 11, 2001, and cheap funding has been pouring into the market ever since. At present, the Merrill analysts said risk capital remains abundant, but this is already changing.

Investment banks and capital-intensive hedge funds made bundles, increasing "value-at-risk" as riskier opportunities turned into positive "net-present-value" investments in the lower financing cost environment, the analysts observed. As risk capital flooded the capital markets, the yield paid to investors for taking on risks, or implied volatility, fell.

"Proprietary trading desks, hedge funds and private equity houses, all of whom thrive on volatility, have been sucking volatility right out of the market," the analysts said.

"But the liquidity tap started closing in mid-2004. And if current market expectations are anything to go by, then the plug blocking the sink-hole is about to be pulled, and risk capital is going to be drained from the market."

Capital drain will boost vol

It's not a bad thing, however. Just as the flood of liquidity caused volatility to plunge, the analysts explained, as risk capital is drained from the market implied volatility will rise. It's not a swift process, though.

"Risk capital flows are precisely that - flows. The implication is that they do not occur instantaneously. Indeed, the flooding and draining processes take one to three 3 years," the analysts said.

Meanwhile, Asia may be at the forefront of the curve shifting volatility upward, the analysts said, but the bottom there is a while away, too.

"When risk capital withdraws, riskier investments are liquidated first. Asia may therefore be at the forefront of any volatility rise, but the bottom is likely at least nine months away," the analysts said.

The repercussions for hedge funds are perhaps ominous.

Hedge fund shrinkage inevitable

The implication for hedge funds is obvious and unavoidable.

Merrill's analysts "predict that large scale shutdowns and/or consolidation will be required. Nevertheless, hedge funds are here to stay and assets under management may even grow despite an outlook of significantly lower returns."

Moreover, the analysts pointed out that bigger scale is needed in a low return environment and that will naturally squeeze out smaller players.

"The problem for hedge funds is that the abundance of risk capital has driven down returns to a point where many are no longer viable operations, simply because they do not have the scale to generate profits as a business in a low return environment," the analysts said.

"Recent evidence suggests that nervous investors are getting trigger happy about pulling capital out of underperforming funds. Combined with the increasing probability of monthly losses, or 'down months,' this is a potentially life threatening environment for many funds."

The combined impact of having to unwind leveraged positions and the subsequent loss of staff, who in the wake of losses know they are a long way away from the high-water mark for performance fees, often makes a total shutdown the only viable alternative.

An additional threat to smaller funds is the competition for the broker lifeline, the analysts said.

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