Will Pearlman was joking about the first-year results of WP Capital, his Chicago-based hedge fund. "It's been a really tough year but at least we outperformed the VIX," he said.

With

the VIX, the Chicago Board of Options Exchange's index for measuring implied volatility of options on the

S&P 500

, declining by about two-thirds in 2003, Pearlman's lament has been echoed this past year by many option traders who watched implied volatilities slide to their lowest levels in eight years. For funds and traders that employ volatility-based strategies, 2003 proved to be extremely difficult, if not disastrous.

Pearlman admits to having a losing year (he didn't want to provide specific numbers), but acknowledges merely meeting performance goals based on adhering to the fund's mandate is a "small battle to win" and realizes he is in danger of losing the war. Make no mistake: Whether you're a money manager overseeing billions in assets or an individual investor building a nest egg, the goal is to end up in the plus column. In a year in which the major stock indices posted gains of about 22% to 50% over the last 52 weeks, his posting negative returns puts his young fund in survival mode.

No matter what people say, they look at their year-end statement in terms of absolute returns. Sticking to your mandate is of little solace when the redemption requests or orthodontia bills come due.

Getting Back to Normal

After the VIX peaked at 57% at the end of 2002, few traders anticipated the precipitous decline to just 14% over the next 13 months. Perhaps part of the problem was that after several years of high volatility, which began as a function of the stock market's meteoric rise and fall and was compounded by terrorist activities and anticipated military actions, the perception of what constituted normal and appropriate volatilities strayed from historically normal levels.

Returning to Normal
Volatility has come back to historical ranges

Option traders began to believe that implied volatility levels were too low and positioned themselves for a rise in volatility -- a "return to normal," Pearlman said -- without realizing that the previous four years had actually been the anomaly.

Pearlman's fund launched in November 2002 with a strategy description that reads in part: "maintain a long volatility exposure, remain essentially market neutral ... and achieve outperformance during times of financial stress." Typical options strategies would include buying straddles and strangles, getting long calendar spreads or simply buying LEAPs or long dated options.

Tracking Performance, Creating Comparisons and Correlations

Last year, FIMAT Global Fund Services began construction of its Financial Volatility Arbitrage Mediam index (FVAM) to track the performance of funds that use volatility-based strategies. According to Dr. Rami Habib, a quantitative analyst at FVAM, the index

it currently consists of just five funds, and WP Capital is not one of them is in its early phases, "but the ultimate goal is to compile data that provides a comprehensive understanding of the return characteristics of volatility strategies." He hopes the index will divulge the correlation of volatility to the overall market and provide a format for comparing relative performance among volatility-based strategy funds. Since its January 2003 inception date, the cumulative return of the five funds that comprise the FVAM index was -6.4%.

Knowing that volatility strategies produce noncorrelative returns relative to stocks or other asset classes, such strategies can be better applied as part of an overall investment portfolio. The real value of the index will be "to get people starting to look at volatility as an asset class," said Habib.

Habib thinks the CBOE's proposed plan to trade futures and options contracts based on the VIX will make volatility trading more efficient and therefore a growth category. "I believe that once we've gone through another period of expansion and contraction in volatility, that volatility as an asset class will be considered part and parcel of everyone's allocation," said Donald Dale, chief strategist and volatility trader at TF Asset Management. While volatility funds are few in number and are often lumped into the market neutral or long/short, having a benchmark such as the FVAM index should help define and expand the universe.

In the short term, individual traders and money managers that employ volatility strategies are hoping the VIX's recent gain to 17.8% over the last eight trading days is a sign that the expansion has finally arrived. And not to throw good money after bad, but if you survived the great VIX drop of 2003, the current levels would imply that the risk/reward ratio is in favor of employing strategies that would benefit from a rise in market volatility.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.