With the Shiller Price Earnings Ratio hitting its second highest level since Black Tuesday 1929, which ushered in the great depression, volatility selling, “one of the hottest trades on Wall Street,” has been racking up a smooth win percentage and almost unreal risk return numbers. However, professional investors with a more skeptical investing process know that the strategy can go wrong, very wrong, when markets hit rough waters.  Jim Mooney, president and head of public investments at Baupost, is in this camp, according to a Baupost Q2 letter to investors reviewed by ValueWalk shows.

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Baupost Q2 Letter

Baupost Q2 Letter

Baupost Q2 Letter Mentions takeing profits, has nearly $1 billion in dry powder ready to deploy

After liquidating four real estate assets for $150 million, two private equity investments that both generated near $700 million in gross proceeds, Baupost appears to be readying the dry powder to do what it is famous for: finding value when market volatility has weak-kneed investors running for the door.

The most poignant moment in a short volatility investor's career could be just around the corner. Those increasing mass of investors who think markets will remain calm and tranquil well into the future and like their current free lunch of selling volatility will learn the value of risk management at some point. When the market crash occurs, strong hands such as Baupost will likely be around to find value in the market and the hedge fund will put its dry powder to use.

“Over the last several years, one of the most reliable winning bets has been shorting volatility in just about any asset class,” Mooney told investors, referring to those who have captured the spread between higher implied volatility and lower realized volatility.

He notes that as actual volatility has remained muted, profits have mounted. However, a day of reckoning won’t be pretty.  Quoting Warren Buffett, Mooney points to the saying: “What a wise man does in the beginning, a fool does in the end.”

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In other words, a short volatility bet is often best after a major volatility event, not as a market begins to look long in the teeth. This speaks to market timing on when volatility will pick up, which could be the most challenging aspect of such a trade. While Goldman Sachs predicts volatility might return to markets next summer, Mooney isn’t quite so precise, but he does acknowledge that when it happens, Baupost will be there to pick up the pieces.

Mooney says they “cannot know” when that moment when the tranquil market calm will be pierced by a volatility explosion – they don’t know if a volatility spike is imminent or even inevitable – nor do they know if it would result in “cataclysmic results,” even though this remains a possibility.

“One thing, however, is for sure: anyone who is directly or indirectly shorting volatility at the current lows is betting current benign environment will persist,” Mooney wrote, then pointed to a negatively correlated word pairing. “Our experience would suggest that, “benign” and “persist” are not words normally associated with one another.”

In the Baupost Q2 Letter, Mooney estimates that investments linked to volatility “likely runs in the hundreds of billions of dollars,” a fact that could propel a market crash once the snowball starts running down the hill. “Any spike in equity markets realized volatility, even to historical average levels, has the potential to drive a significant amount of equity selling (much of it automated),” which would create a self-fulfilling feedback loop that only builds upon itself.

While Baupost doesn’t engage in the fool’s errand of attempting to predict the exact time and date a market crash will occur, the value-based hedge funds does consider the macro market environment and notes that the artificially tranquil environment that has put markets to sleep has lasted “longer than we would have imagined.”

Baupost Q2 letter recognizes that assets are “broadly expensive” and they are exposed to the market but “largely indifferent to risk” as they have a hedging plan and are cognizant of risk.

Considering the words of Hyman Minsky, whose “Minsky moment” is defined by a sudden market crash after long periods of market prosperity, Mooney recognizes that “no one should be lulled into a false sense of comfort by the illusion of stability which surrounds us.”

When contacted by ValueWalk, a spokesperson for Baupost declined to comment.