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Monday 24 December 2012

Investment Sector Outlook for 2013: “Volatility in Vogue”

At FPM we understand that checking in the rear-view mirror is not only an indicator of ‘things that have come to pass’ but augurs ‘things that may come to pass’. So for the year-ahead, when investor psyche is most trained on forward-looking signs, we aim to present a strategy research. These market intelligence or views are confirmed by our Exchange Traded Product (ETP) diligence. Our use of ETFs reinforces FPM's integrity as a multi-manager / FoFs platform credentials.
A comprehensive list of all ETPs ranked by YTD performance on 14th Nov’12 serves as the starting point for short- and medium-term view recommendations. We believe this ranking-list and ETF prices as at end-month Nov’12 serves as an apt data-point in spite of year-end window-dressing noise. Following ETP data refers to these dates unless stated.

“Volatility in Vogue”

Volatility as an investment sector, according to our ranking of all ETFs performance at US equity market close on 14th November, was one of the punch-the-lights-out asset classes of 2012; but ONLY if you were in a proxy that was short a volatility benchmark like the VIX Index, as below:

XIV VelocityShares Daily Inverse VIX Short-Term ETN $16.07 -3.48% $370,052 11,384,800 146.85% Volatility ETFs

11,384,800 146.85% Volatility ETFs

VelocityShares Daily Inverse Short-Term ETN ‘XIV’ posted a staggering 151.5% annual total return for year-ending Nov’12 (see below table of all ETFs over year). With approx. $370 mn in assets it is the 2nd biggest of volatility ETFs. Our universe for this sector study, incorporated all 17 volatility ETFs, as classified by ETFdb.

FPM’s macro perspective envisages an inevitable pick-up in volatility, at least a 68% probability event, based on the volatility exhibited in VIX in the window period since Jan’09. Our expectation for increase in equity volatility in 2013, especially after the relative lull in volatility this year, stems from market-related macro concerns reverberate strongly.  
FPM recommends a SWITCH trade with accompanying trigger-event date. We favour the Barclays ETN Inverse S+P 500 VIX Short-Term Futures ETN (XXV) for expectation of benign volatility levels in 2Q13 and 3Q13:

Barclays ETN Inverse S+P 500 VIX Short-Term Futures ETN$37.75unch$4,5795,22114.39%Volatility ETFs

From our market understanding and statistical observations presented in below tables, and without looking under-the-bonnet, the ‘XXV’ is one of the smallest-hitting ETFs in the volatility class:  with only about $4.5 mn in assets we’re mindful of liquidity concerns. Yet FPM commends it for:

a) Its forerunner launch in Aug’10, beating or setting the trend for a hoard of other volatility ETF launches in Nov’10; these others exhibit poorer ‘me-too’ arrivals. We noticed 6 ETFs incepted in November that year from the VelocityShares stable alone!
b) Its relatively longer track-record through business cycles is validated with strong adjusted closing price performance 59.5% total return since inception.
c) Other favourable FPM metrics in statistical comparison with peers in the class, e.g. low market correlation, lowest monthly loss of only -2.3% across all 17 ETFs and benchmarks, further encourages us to kick-the-tyres and check-under-bonnet for allocation before by January 2013. See below for all ETF performance since their inception.

We perceive volatility increasing in 1Q13 to above 20 level as year-end dust settles and New Year optimism and hope springs eternal i.e. risk-on activity. We expect volatility surges throughout the year with the Fed’s FOMC stance about suspending its ZIRP or interest rate capping policy, or indeed other policy-drivers. Recently these factors have been prominent in capital market direction and volumes.

Barrons Focus on Funds reported on the December 21st:

“…Wall Street appeared to expect an interim deal today [on “fiscal cliff Jackanory”], followed by more meaningful resolutions in early January. Earlier, January and February futures on the Chicago Board Options Exchange’s Volatility Index were up 7%, and 6%, around 19, respectively. The “VIX” nearly surpassed 20 for the first time [since June 25th closing] in a while this morning and has pared it gain to 5% or so at this writing.”

For this 1Q13 increased volatility scenario FPM RECOMMENDS the sector bellwether, un-leveraged long volatility short-term VIX tracker, the VXX for sheer volume and liquidity for market-timing directional trading.

Volatility ETFs from Micro Perspective

Volatility as an ETF asset class ultimately tracks the CBOE Volatility Index, otherwise known as the ‘VIX’ or ‘Fear gauge’. The VIX, introduced in 1993, is calculated from prices paid for S&P 500 index options expiring in the next 30 days. Though it has been around for nearly 20 years, by the vary nature of its calculation it is not an investable asset. The ETPs in the volatility category of the ETFdb database, actually invest in VIX futures or, in the case of ETNs, are linked to indexes comprised of VIX futures.

The generally passive index-tracking nature of ETFs is somewhat algorithmic and prudently warranty case-by-case black-box examination. Traditional long-volatility funds bought derivative contracts with implied future volatility, betting price swings will increase. When volatility is steady, the derivatives lose intrinsic and time value moving to maturity, resulting in losses for the funds. Hence the reasons why the two best performing ETFs in our study are short volatility (inverse volatility), in this relatively calm markets.

Of long volatility ETFs there is distinction in whether they reference short-term duration VIX futures (usually offering exposure to 1st or 2nd month futures contracts), such as ‘VXX’, ‘VIIX’ and ‘VIXY’ etfs; or link to medium-term duration VIX futures   (exposure to 4th month through to 7th month contracts), such as ‘VXZ’, ‘VIXM’ and ‘VIIZ’

Short-term exposure generally exhibit higher correlation to changes in the spot VIX (high beta). But because contango is often steepest at the short end of the maturity curve, the adverse impact of an upward-sloping curve may be more severe. Indeed short-term exposure ETFs fared worse over the year and since inception than medium-term exposure VIX etfs. And as expected leveraged long ETFs ‘TVIX’,’TVIZ’   

VXX, and other long volatility short-term durations ETFs usually face higher rebalancing related trading costs from periodic portfolio turnover especially in contangoed VIX futures markets. This results in a premiums paid to roll-over index option positions, i.e. the “roll yield” resulting from contangoed markets. Contago in futures is when the futures price is above the expected future spot price. Consequently, the price will decline to the spot price before the delivery date. This is the opposite of backwardation.

Micro drivers for volatility performance

While volatility ETFs are not recommended as long-term buy-hold vehicles, they do provide opportune trading and hedging possibilities.

The appeal of ‘pure’ long volatility exposure via VIX futures is due to its strong negative correlation to equity markets. Correlation ratio -0.83 of VIX to S+P 500 over the past year. So volatility can be thought of as insurance for investor portfolios. Market traded volatility products such ETPs tend to exhibit weaker negative correlation, as our quant analysis shows. The study in fact shows that there low correlation of long volatility etfs with S+P 500 index in the past year of benign volatility. The median correlation for long exposure ETFs was 0.24.

Apart from understanding the variables for implied volatility calculations, FPM monitors outstanding options on the VIX as auguring volatility price-action. For instance outstanding positions on the VIX rose to 9.01 mn on 16th October, the most ever according to Bloomberg data.

Our study also found that CBOE Holdings Inc (owner of Vix) said in September that it intends to expand trading hours for VIX futures to 24 hours from 8, five days a week, starting in 2013. We can expect increased liquidity in volatility trading, which may equally dampen or exacerbate volatility spikes depending on the degree of herding in particular views on asset class direction.

The ability to manage volatility similar to that of US equity markets is developing with domestic futures and option exchanges globally. For example, futures on volatility gauges for the Nikkei 225 Stock Average and Hang Seng Index started in February of this year.

Other benchmarks such as HFRX Global Volatility Index may also get monetised expanding scope of diversified volatility management.
The main factors other than being long or short of the stated volatility index:

Ø      Two volatility ETFs are approaching thier meaningful 3-years track record – the first of 17 in the universe incepted in Jan’09 (VXX)
Ø      The oldest volatility ETF (VXX) is also the largest with $1.6 bn+ in assets at Mid-November. The smallest one has ~$1.8 mn in assets (IVOP)
Ø      Volatility as an asset category is classified under alternative investments by prominent ETF vendor  ETFdb (with Hedge Funds and Long-Short ETPs)
Ø      ProShares VIX Short-Term Futures ETF (VIXY) is the only ETF approach in the space, others are notably Exchanged Traded Notes ETNs.
Ø      Only 5 of the 17 volatility ETFs (VXX, XIV, TVIX, UVXY and VIXY) characterised daily average volumes over 1 mn shares traded; solid volumes indicates tight bid ask spreads
Ø      Another not small consideration in ETF allocation are the ever present management fees, which is relatively the lowest of various fund sectors, for basic index replicating performance.

We noticed that being short or long volatility is an event-based trade. Often described as ride to the sound of the trumpet, and then take profit when there! We identified ‘3 P+L  periods / option-settlement-rollovers’, Feb, Apr-May and Aug-Oct, were profit/loss taking months for institutional ETF players, depending on which side of the long/short volatility net position. Typically volatility may be expected to surge in October, as investors try to exit losing positions before the end of the year.

The short-term long volatility ETFs experienced their worst monthly price-basis drawdown in Feb’12 losing between -31.5% and -55.8% (bear in mind that this ETF class is only approaching its 3rd year of existence). The short-term derivatives investing inverse volatility ETFs (essentially puts on S+P 500) experienced their worst monthly drawdown in Apr’12 ranging between -2.3% and -25.5%. FPM SWITCH RECOMMENDATION the ‘XXV’ and the VOGUE STAR PERFORMER ETF ‘XIV’ experienced a modest monthly -2.3% and the worst drawdown of -25.5% respectively. The medium-term long volatility ETFs took worst monthly loss in Aug’12 averaging -17.1% with outlier performance of -31.7% from VelocityShares Daily 2x VIX Medium-Term ETN (TVIZ), due to its 2X leverage. 

At this stage we also present a Long/Short VIX ETN. A discovery from FPM analysis of statistics, that finally recognises a hedged volatility tracker.

Another of the creative combinations of the exchange-traded structure and volatility is the UBS E-TRACS Daily Long-Short VIX ETN (XVIX), a product designed to exploit the steepness on the short end of the VIX futures curve. XVIX is linked to an index that maintains a 100% long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a short 50% in the S&P 500 VIX Short-Term Futures Index Excess Return (an inverse-ETF position). The result is a product that offers non-correlated exposure but hedges out exposure to the short-term index, making it a potentially interesting for investors looking to achieve exposure to volatility over a longer time period. During Wednesday’s session, XVIX lost about 1%, a result to be expected then the gain on the short-term futures index was more than twice as large as the change in the mid-term index…” [Source: Michael Johnston of ETFdb on March 21, 2011]

FPM adduces that most ETFs, at least in the S&P 500 option volatility space, experienced the biggest drawdown synchronised with clearing months for futures and options settlements calendar. Participants took money off the table / or switched trades in the volatility space, based on ambiguous or benign economic and regulatory event-drivers. Catalyst-drivers for the markets and wider economic sentiment are orchestrated by authorities in ostentatiously retaliatory stance for financial crisis and aftermath. Before the Lehman collapse the markets were crying foul of buyout-centric momentum-driven trading disrupting company fundamental valuations. And now the macro fundamentals are driven by global statutory agents. The point being that presiding investor sentiment on the prevailing macro policy issues also caused profit / loss taking in volatility ETFs.

Completing our micro event-driven 'regs-news' for volatility ETFs we edited together our ‘Prescient People News Annual’ of ‘proper’ macro and market policy issues (as distinct from ‘news noise’), as below:

Volatility from a Macro Perspective

Re-emergence of macro economic concerns, through escalation in state and national debt defaults – by whatever label and however well stage-managed the propaganda and behind-the-scenes debt restructuring progresses amid the de-leveraging cycle. We refer you to Ray Dalio’s “D-Process” as an expert’s long-term macro view. Currently, the synthetic economic confidence efforts (QE, TALP, TALF, Tax-holidays etc) and general lifeline provided by global central banks is keeping the global economic ship on a steady / even keel i.e. mitigated risks scenario. Remember it’s not that long ago were there concerns about global bank solvency. A once profligate wealthy sector is now transferring its credit-boom-bust losses to future taxpayers! FPM knows that even a hedge position can have a downside – if confidence and economic activity is not restored in balance!

On this Chicago-school of monetarist policy path, a scenario of Europe or other nation or bloc-state running-out of money and/or stopping-the-printing-press via geopolitical pressures like populous uprising, could make recent solvency issues of financial institutions and the housing sector seem a mere trifle. Statutory monetary expansion to quell systemic credit market risks of 2008 has exponentially ballooned national and fiscal balance sheets / debts. For example, US Total Public Debt Outstanding is US$ 16.3 trillion!   The souring of these government / state debts, currently and seemingly only affecting irresponsible fiscal management fringe countries and municipal states, blowing up i.e. credit default risks, is not an incorrigible reality. viz. Greece et al / ‘PIIGS’ and California  See below for more on “Volatility in a Macro Perspective”.

We can see from VIX chart below that since the frenzied life-time high level of 80 in Oct 27 and Nov 20 following Lehman bust in Sept’08, equity market swings have been less volatile, none more so than in 2012, at pixel time. CBOE Volatility Index or VIX is now around a five-year low, reflecting a steadied-ship which is the global economy proxy of S&P 500 constituent options’ implied volatilities!
For the record, before the Lehman bust, the VIX level rose to a five-year high of 32.24 on Mar 17, 2008 the day after the Federal Reserve rescued Bear Stearns. The VIX fell for four straight years through 2006 and slid to a 14-year low of 9.89 in January 2007, a month before the first reports of subprime losses. Previous highwater mark for VIX was 45.74 in Oct 1998, when the collapse of Long-Term Capital Management LP destabilized financial markets worldwide. Then of course cliff-fall in market sentiment sent fear gauge to 80 levels in Autumn 2008. Can anyone see the lull-before-the storm playing out again in similar yet shorter via volatility trading?

Source: Yahoo.com and FPM

The “plaster-policy-fix recovery” in housing and financials from maelstroms of the past is an opened Pandora’s box. This author remembers how the developing nations defended a run on their sovereign currency during the hot-money capital flight. For example, the Thai Bhat’s devaluation was the catalyst for the Asian financial crisis in 1997-98. Only after hardy-denials of the insurmountable problems did the national authorities capitulate and accept realities of bubbles. Just as we now have ‘troika’ restructuring nearly-out-of-control European fiscal and national debts, Thailand then also had the IMF satraps pushing and shoving national prestige into accepting the capital malfeasance facing it and the region. In a similar fashion, those liberal marketeers not living in ostrich paradise definitely envisage other indebted European nation following the way of Greece et al, leading to the final capitulation of the European exchange rate mechanism. 

The behavioural finance aspect of the “collective institutional market psyche” is an interesting aspect of understanding the reduced equity volatility in 2012. In the context of the cycle in this double-dip financial crisis, sometimes we get so inundated and eventually fatigued by, or simply get used to scandalous corruptive news that we hardly register them, never mind taking uproarious action. The Libor-fixing revelation hardly caused a tremor, as reaction in the global equity markets this year, though its rate setting effects trillions of referenced debt assets! Incidentally this indicates the markets’ predilection and state of readiness for a crisis. Hedges were at the ready and Libor-news-risk volatility safely mitigated for now.
A certain period of inveterate state in society and / or institutions can stifle conscientious objective thinking, breeding hubris and complacency maybe dare we suggest stagnation-economy. Such as those of the disenchanted or disengaged economic workforce, who are and were once productive units in cooperative societies. Those who are long-term unemployed or in the conditioned-‘Black-Economies of the World’ could reassert themselves gainfully. In some developing countries women are now being considered to join workforce – Wow! To increase economic activity or perhaps a liberalisation of the alter-ego of economics - no less! Of the inveterate state of societies’ conscientiousness or interest in self-governing facts, we are lazy or unspoken majority! When time framed status-quo societys’ behaviour and expression changes, suddenly and unexpectedly then panic arises and the diligence becomes collective mass fear-flight to switch asset holdings. They are dynamics of the fast world we domesticate. 

Litigation surrounding Libor and related-banks should cause mainstay financial institutions’ equity to stay in the mire of regulatory and litigious uncertainties for longer. This to us means that the conventional banking business model is in a state of slow flux. One might say ‘alternating’ flux! Allocation buckets for financial investments is switching to Emerging Alternative Asset Managers. (email me for FPM’s fund manager transactions ‘FMT’ efforts)

Equally as interesting to consider that equity trading volume and general market direction has been at range-bound levels, has contributed to lower volatility. At the end of the first week of this month December, the YTD daily average volume is about 6.48 bn shares changing hands on the New York Stock Exchange, the Nasdaq and NYSE MKT. At end-1H12 trading volume was again light, with about 15.72 bn shares traded on aforementioned bourses, well below 2011 daily average of 7.84 bn.

Other Volatility Plays:

There are so many ways to play volatility, and volatility systems typically perform best when “everyone else is confused” and / or when “excessive fear or greed among investors exist” or “it would require something to happen that is unknown today”!
Other than ETFs there are other portfolio vehicles and investing strategies to understand and profit from this volatility asset class. That is, up and down swings can be a defining material investment, if principals / managers are “swinging” in their investment outlook and approach.

Listed below are 4 Low-Volatility ETFs to Hedge Portfolios, as reported by Zacks.com:
PowerShares S&P 500 Low Volatility (SPLV) - SPLV tracks the S&P 500 Low Volatility Index, which consists of 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Est.May’11 with current AuM ~US$ 2.6 bn.
iShares MSCI USA Min Volatility (USMV) - USMV seeks to replicate the MSCI USA Minimum Volatility Index, which is comprised of U.S. securities in the top 85% market cap that have lower absolute volatility. Est.Oct’11 with current AuM ~US$ 465 mn.
iShares MSCI All Country World Minimum Volatility Index Fund (ACWV) - It tracks MSCI All Country World Minimum Volatility Index. Est.Oct’11 with AuM ~US$ 639 mn
iShares MSCI Emerging Market Minimum Volatility Index (EEMV) EEMV is an ideal choice for the investors looking to participate in the emerging markets growth while limiting their portfolio volatility. Est.Oct’11 with AuM ~£603 mn.

Index Replicators like ETFs produce average performance i.e. sector beta returns. However, alpha stars in hedge funds with the right redemption / exit terms are the ones perform best. If

The HSI Volatility Index (VHSI), a measure of Hang Seng Index (VNKY) option prices, is also possible volatility play on wider markets; other than of course thr widely accepted volatility benchmark of the S&P 500 companies.
As is the HFRX global volatility index which gained 7% this year to Oct’12, outpacing the 4.8% advance of its broader measure of hedge funds.

Of Volatility Hedge Funds: we initially examined sector specialists from the smaller Asian universe. Our findings suggest there was a creative-destruction bias, at least in long-biased volatility hedge funds. Artradis Fund Management in Singapore ran two volatility funds accounting for most of its US$ 4.5 bn in assets in early 2009, propelling it to Asia’s third-largest hedge-fund group. It reportedly made US$ 2.7 bn for investors as markets seesawed in 2007 and 2008. Artradis closed in March 2011 after its funds lost US$ 700 mn in 2009 and 2010. Artradis comprised former colleagues of Asia-office of Fortress Investment Group who had started the Fortress Convex Asia.

Another example of transactional creative-destruction in hedge funds is the Sharp Peak Vega Feeder Fund, which invested in OTC equity derivatives including volatility swaps, lost 12% in the first half of this year and 18% since it started in Oct’11. The Hong Kong-based manager has now shuttered shop. Another Hong Kong-based manager, DragonBack Capital, which managed as much as US $600 mn at its height of fortunes in 2008, also closed in Aug’10.

To get material proportion in the advance of volatility trading trends we compare scale of Euro-Asia Volatility Markets. Asia-based volatility funds tracked by Eurekahedge Pte managed US$ 212 mn of assets as of June, less than one-tenth of the mid-2008 peak. In comparison, Newedge’s index of hedge fund volatility sample of 10-fund constituents alone managed a combined US$ 4.6 bn approximately.

On an encouraging note of “letting your work be your fight…”, Stephen Diggle of the failed Artradis FM and of ex-Fortress team, had started Vulpes Long Asian Volatility and Arbitrage Fund with mostly his own money, a couple of months after in May 2011: “…He’s betting on price swings for government debt, currencies and commodities.”

FPM seeks to engage Vulpes Investment Management with salutation of: “…let your peace be a victory.” [Ki Action Point]

Closer to home we are closely following the fortunes of Maple Leaf Capital in London. Passing their tenth anniversary of operations earlier in May. Congratulations Men! Maple Leaf was founded by Michael Wexler and George Castrounis, specialising in volatility trading and arbitrage across equity, commodity, currency, and fixed income markets.

FPM is engaging them and others on a sector marketing diligence mission for in-depth coverage and peer study. Peers which we will follow-up on include JD Capital with similar operations establishment date in 2001, with a strategic prominent FoFs backer FRM Capital. Also JD Capitals Tempo Volatility Fund is part of the 10 constituents of the NewEdge Volatilty Index.

Finishing on an anecdotal note we extracted these two statements from our web-trawl research, one ironic and the other validation of volatility assets:

``You're either going to be buying at the bar tonight or crying! There's enormous opportunity if you're an options player because the volatility is there and if you hedge it right, you don't care if it's up or down. But if you don't do it properly, you can lose a lot of money… The [S&P 500] index may have its most volatile year since 2002. ''
Howard Silverblatt, an analyst at S&P in New York, commenting days before Lehman’s blowup.

``They make money when others don't. They act like insurance in one's portfolio.'' Antonio Munoz, CEO of EIM Management USA, a unit of EIM Group of Switzerland, commenting on volatility funds it has held since 2002.

On behalf of FPM I wish my friends and colleagues and web-trawlers the best of season’s festivities and holidays.… let our peace be an all deserving victory.

[@pixel time Ed deeply watching and then breaking-off from movie “The Abyss”, Tomorrow evening looking forward to hanging out with my special fasionista connections’ family in airy Cornwall.]

‘Seasons Sentiments & Cya in 2013! xk’