In Search of the Elusive Black Swan Hedge....Here's One Good Idea

My approach to investing is heavily influenced by both traditional finance and behavioral finance. I believe that the markets are "weak form" efficient. That is to say it is near impossible to consistently have an "edge" due to information (of the legal kind) or other skills that would lead an investor to consistently outperform the relevant market index through stock picking and market timing.

On the other hand I certainly do not believe in "strong form" market efficiency: that all prices always represent a rational evaluation of all available information so that not only are the markets efficient they are also rational: price=value. It seems unbelievable to any layman that it is controversial to assert that markets can be irrational and prices deviate from any reasonable sense of value yet in fact in academic finance this is indeed a source of controversy. It is pretty clear that markets overshoot: bubbles and busts exist.

But the fact that irrational under and over valuation occurs does not mean that money can be systematically made identifying them. As Keynes and many others have pointed out you (trading against the market irrationality) can run out of money before the market comes to its senses.

I am not looking for a systematic way to call market tops or bubbles, I don’t think they exist. I am far more interested in finding ways to limit the exposure on the downside of a portfolio due to “black swan” events. The expression made famous by Nicholas Taleeb in his book The Black Swan. Such events would be defined as unlikely events with disastrous circumstances, bursting of bubbles, or other low probability events that could have disastrous consequences on a portfolio.

Earlier this month I attended a major ETF conference at Boca Raton Florida. I thought I would get some ideas from a panel entitled “controlling tail risk” –tail is the geek term for the extreme outlying points on a bell curve i.e. low probability events. Ironically enough the conference was held in the midst of a “tail” event in south florida weather: temperatures were in the 30s, the local weather report even included the wind chill data. Yet the panel discussed things like “understanding your client’s risk tolerance” and “risk tolerance questionnaires with not a word of actual discussion of limiting portfolio risk to extreme events. It would have been a bit like having a panel on preparing for unusually cold weather during a January trip to Florida and devoting the discussion entirely to the issue of how sensitive you are to cold rather than the types of warm clothing it might make sense to pack as a precaution.

Needless to say, I didn’t get any ideas from the panel. Since I have years of background in options I know that the most direct way to protect against extreme downside moves is to purchase out of the money put options. While this is certainly the most direct hedge for a portfolio, there are several factors that may argue against this approach which I will detail in another post.
There is another alternative which may be more attractive. When one buys a single option one is effectively buying a view on both the underlying security's direction and on volatility. An option price is based on the markets view of future volatility (“implied volatility”) the relationship of the option strike price to the price of the underlying, and the time to expiry.

It is possible to “buy (or sell) volatility” without seeking to profit from movement in a particular direction through the purchase of options The most prevalent way to do this in most markets is to buy or sell an “at the money” straddle = a put and call both with strike prices at the money (at or close to the current market price).

But there is another way to” trade volatility” on the s+p 500 through the vix index which is the “implied volatility of at the money options . Up until very recently this could only be done through a futures contract. But through the use of an etn (exchange traded note) one can purchase an etn on a volatility index which moves tandem to but is not identical to the vix. The etn has the ticker symbol vxx, and it is based on an shirt term futures on the vix volatility index.

The VIX is often referred to as the “fear index” with much justification. As markets become fearful demand for options goes up and is reflected in higher option premiums higher implied volatilities on options and a higher VIX. Quiet markets on the other hand bring the vix lower. As it turns out, holding a long position in volatility through the volatility etn VXX has many characteristics that make it an attractive hedge vehicle arguably more attractive than options purchases. While we do not have long term trading data for the vxn it’s general price behavior corresponds to the vix which has a longer history.

1.The vxx has a very high inverse correlation to the S+P 500. =-.74 Large down movements in the market are accompanied by very large moves up in the vxx

2. The vxx tends to move a multiple of the size of the market movement in periods of sharp declines. Therefore a relatively small position in the index can offset movements ina large part of the portfolio.

3.Although the vxx will decline during periods of low volatility it will not go to zero. There might be large losses on the hedge but unlike options the position need not go to zero because of price movements in the underlying index. There is credit risk on the instrument since it is an exchange traded note. It is conceivable that in the event of a bankruptcy of the issuer: Blackrock, the value of the note could go to zero.

4. Unlike options a large volatile to the upside for the portfolio will not create losses on the hedge, just the opposite, there is a likelihood that a market that is volatile on the upside will lead to an increase in the vix and therefore a “windfall gain” on the hedge.


5. Since nothing goes up in a down market except correlation, a position on the vix even though it is based only on the sp 500 is likely to serve as a good head for a global portfolio. Major downmoves in the US market are seldom unaccompanied by large drops in global markets. And it seems to be increasingly the case that major downturns in non us markets spillover into the us market.

During 2008 the spy 500 experienced a 50% fall, the emerging market a drop of 60%, yet the vix index experienced an increase of 400% at its highest point and ended the year 100% higher than where it started.

The pattern was similar although not as extreme during other sharp market drops: selloffs the magnitude of the increase in the vix was multiple of the magnitude of the fall in the underlying market. A stable market leads to a decline in the vix (all time low is around 10 )big upmoves in the market lead to upmoves in volatility but nowhere near as high as during sell off

For that reason a relatively small position in an etn linked to the vix has the potentially of acting as a hedge against large negatives moves on a far larger portfolio. In the extreme example of 2008 a $22,000 position in the vxx would have offset the losses on a $100,000 position in the s+p 500.

Several factors may argue for using the volatility etn as a “black swan” instead of purchasing out of the money put options:

Leverage: as mentioned during the negative black swan events volatility is likely to move up a multiple of the move in the underlying. In fact the leverage on this instrument tends to work in the hedgers favor the move up in volatility in a panic is far sharper than the decline in volatility in response to quiet markets

Bad correlation becomes good correlation: the phenomenon of “the only thing that goes up in a down market is correlation” helps this strategy as the hedge on us mkt volatility works as a hedge of a global equity portfolio.

There will never be a total loss on the hedge due to market movements in the index. Unlike options even in dead markets the volatility index will not go to zero thus the drag on portfolio returns from the hedge is not as great.
There is, however, credit risk related to this instrument, since it is a note issued by ishares/blackrock in the event of a bankruptcy by the issuer the note value could decline significantly or even go to zero regardless of movements in the volatility index.

Possibility of windfall gain. Should the markets move up sharply the investor hedging with the volatility index will reap a windfall gain. Both the underlying long portfolio and the hedge (the long volatility position) will increase in value. In the case of the put option purchased as a hedge there of course would be a sharp decline in value.
Rolling of strikes and maturities. The volatility etn is a “perpetual index” so there are none of the complexities described above with regard to option positions.
The strategy worked well during the current market decline
Between Jan 20 and Jan 26 the vxx rose from 27.81 to 31.72 an increase of 14%
The sp 500 during that time fell from 113.89 to 109.31 a fall of 4%
So for a$100,000 portfolio invested as follows
$95,000 in sp 500 loss of $3600
$5,0000 in vxx the hedge would have created a gain of $700
For a net loss of $2900

And a portfolio fully invested in the sp 500 would have generated a loss of $4,000
So the hedge with only 5% of the portfolio created a loss 27.5% less (-$2900 vs -$4000) than an unhedged portfolio.

And as is usually the case in significant down moves markets move in tandem the emerging markets index has fallen 6.6% over the same time frame, developed markets: 7%. So the purchased of the us volatility etn would have functioned as a hedge of a global stock portfolio,

So while there certainly is no such things as a perfect hedge that protects the downside and retains the potential for upside gains…the volatility etn is certainly merits consideration as part of a portfolio.

Do People Never Learn ?

To see the managers responsible for the pensions of tens of thousands of employees attempt to secure the future retirement income of those people by increasing their risk is amazing. What's worse is that when these strategies blow up and create large losses, the taxpayers will be on the hook to make up the shortfall to meet the financial committments to the public retirees. It's bad enough to see individual investors fall into the traps outlined so well by researchers into behavioral finance. To see the same behaviors: unrealistic expectations of returns, use of leverage and underestimating the riskiness of a strategy, faith in "genius managers" by "professional managers" is jaw dropping.

And it is clear from the article that the pension managers are jumping from one strategy to the other inevitably chasing past returns....and "consultants" and managers from Wall Street are at the ready to offer the latest and greatest new strategy.

The losses that these same institutional investors suffered in hedge funds and private equity showed that there is no prospect of increased returns without increased risks. The large returns of these strategies that attracted these investors masked the fact that the higher returns came at greater risk due to leverage and illiquidity. I have a sense that the same will happen with the new "hot" strategy to boost returns.


from the wsj my bolds and my comments in blue



JANUARY 27, 2010

Public Pensions Look at Leverage Strategy

By CRAIG KARMIN

Public pension funds needing to boost their returns but frustrated with hedge funds and private-equity investments are turning to one of the oldest investment strategies—using borrowed money to boost performance.
The strategy calls for leveraging pension funds' safest asset—government or other high-grade bonds—while reducing exposure to stocks. 

 It's not completely clear from the article what the strategy is composed of but it seems to be composed of leveraging up bond holdings to buy more bonds while reducing stock holdings. This would be a variation of the sort of carry trade that many investment banks are pursuing financing short term at very low rates and investing longer term with the bond holdings. While the immediate environment may be attractive for this strategy it is hardly riskless. Long term bonds bottomed last year after a tremendous rally : treasury bonds rose in a flight to quality in 2008 and have pretty much declined in price since then. Corporate bonds recovered in 2009, the economy improved and spreads of corporates over treasuries declined bringing prices up.


At this point it would seem that most of the easy money has been taken out of these strategies :interest rates are likely to rise as the fed unwinds its easing strategy. The result would be doubly negative for the strategy: financing costs would go up and there would be capital losses on the bond holdings. I am getting the uncomfortable feeling that these pension managers are chasing returns, entering into a strategy just as the prospects for its success are declining. Will they be nimble enough to avoid the double whammy of higher financing costs and lower bond prices that will accompany a future move up in interest rates...I doubt it. And there is little doubt they are dialing up the risk in search of higher returns.

The State of Wisconsin Investment Board, which manages $78 billion, became among the first to adopt the strategy when it approved the plan Tuesday. The fund will borrow an amount equivalent to 4% of assets this year, and as much as 20% of its assets over the next three years.
Fund officials say that use of leverage could eventually go higher—in theory, at least, up to 100% of assets, according to the staff analysis. But Chief Investment Officer David Villa says that level wouldn't be palatable for the Wisconsin fund. He said the pension fund was advised by four money managers, including Connecticut hedge-fund firms AQR Capital and Bridgewater Associates

It is interesting that AQR Capital is involved in this. Just last Saturday in a WSJ excerpt from what seems likely to be a great book on the fiinancial crisis entitled The Quants by Scott Patterson we get the following description of Mr. Asness' firm AQR struggling in the midst of the 2008 financial meltdown as his fund was suffering extensive losses.:

The quants did their best to contain the damage, but they were like firefighters trying to douse a raging inferno with gasoline—the more they tried to fight the flames by selling, the worse the selling became. Quant funds everywhere were scrambling to figure out what was going on.
Tuesday, the downturn accelerated. Applied Quantitative Research, the Greenwich, Conn.-based quant fund giant run by former Goldman Sachs Group whiz Cliff Asness, booked rooms at the nearby Delamar on Greenwich Harbor, a luxury hotel, so they could be available around the clock for stressed-out, sleep-deprived quants.

Not only was Mr. Asness current fund bleeding money the fund he created at his previous employer was quite possibly at the center of the market meltdown:

Nervous managers traded rumors by email and phone in a frantic hunt for patient zero, the sickly hedge fund that had triggered the contagion. Many were fingering Goldman Sachs's Global Alpha, the quant fund founded by Mr. Asness in the 1990s that had grown to massive proportions. But no one knew for sure.

The article on the pension funds continues:

Wilshire Consulting, which advises pension funds on investments, says leverage helps the funds meet their long-term return targets without relying too heavily on volatile stocks, or tying up their money for long stretches in private investments. Low interest rates make it impossible to meet those targets with simple bond investments. Wilshire managing director Steven Foresti says he has been in discussions with about a half-dozen funds that are interested in the leverage strategy. ..

My views are certainly in line with these skeptical views in the article in pension funds' new strategy:

That public pension funds would contemplate the use of borrowed money so soon after a credit crisis stoked by financial leverage is already setting off alarms for some in the industry.
These analysts wonder if this is little more than the latest gimmick peddled by investment consultants. In previous years, consultants pitched a strategy called portable alpha, an aggressive bet involving leverage and hedge funds that magnified returns when the stock market was surging but aggravated losses when the market turned down.
"When people reach for return with non-traditional approaches they can take on risks they don't fully appreciate," says Daniel Jick, head of HighVista Strategies, a Boston-based firm that manages money for small schools and other investors. As many investors found out in 2008, he added, "using leverage can force you to sell assets you'd rather not sell."
Moreover, he questions the timing of leveraging bonds when many economists are forecasting a pickup in inflation and an increase in interest rates as the economy recovers. That would cause bond prices to fall, and leverage could magnify those declines.
Some advocates of the leveraged approach acknowledge these drawbacks, but say the strategy makes sense anyway. Most big public pensions have expected annual rates of return between 7.5% and 8%. Wisconsin, for example, assumes 7.8%.
Many analysts consider those return rates unrealistic. Yet pension funds are loath to change them because that would require local governments to get more money from taxpayers to compensate for lower projected returns. Even at an 8% return, the average public fund will have about 55% more in liabilities than in assets 15 years from now, due to recent losses and challenges in raising contribution rates, according to PricewaterhouseCoopers.
Most pensions piled into stocks in the late 1990s, counting on a booming market to increase assets, which in turn allowed these funds to increase retirement benefits or reduce state contributions. Since the tech-stock bust, however, many pensions became queasy with the volatility attached to stocks and have been trying to find a substitute to help meet their return targets.
During much of the previous decade, many pensions thought they found the answer in private equity, which put up big numbers. But these funds collapsed in value in 2008 alongside the stock market while locking up pension fund capital for 10 or more years.
"We started talking to the board about this two years ago," says Mr. Villa, Wisconsin's investment chief. "It would have been nice to have this in a place prior to the crisis." That's because the strategy calls for leveraging assets that held value in 2008, Treasurys and other highly rated bonds.

Could there be more evidence than the above that the fund managers are flailing in their quest for unrealistic returns grasping at a strategy primarily because it worked in the past 2 years ? No doubt the consultants and money managers had great powerpoints emphasizing the past returns of this strategy highlighted by the outsized returns of 2008.

The losses in private equity and hedge funds that the pension funds experienced in 2008 should have taught them 1) that leverage is a 2 edged sword magnifying both gains and losses 2) In extreme market moves leveraged positions could trigger force liquidation to meet margin requirements leading to selling assets when they are extremely low values . But instead of reducing the amount of investments of any type that involve leverage these managers misread the lessons of the past. They have simply moved their leverage from one market to another not eliminating the fundamental perils in leveraging.

Some pension fund managers seem to actually believe that the newest "strategy" being peddled by Wall Street (as noted above the last faddish idea "portable alpha flopped) can turn stones into gold or at least give equity like returns with fixed income type risk in an amazing act of financial alchemy. Considering one firm peddling it was put in crisis mode in 2008 as it faced a blow up of its strategy at that time, I think caveat emptor is very good advice indeed.

"Fixed income is a good hedge in a crisis scenario," says Rick Dahl, chief investment officer for the Missouri State Employees' Retirement System, who said he is considering using this strategy. "If I can ramp up my fixed income to the point where it gets equity-like returns that makes a lot of sense."
But he isn't yet convinced. "I'll need to think through all the ramifications, too," Mr. Dahl said.

 I would point out to Mr. Dahl that treasury bonds (not all fixed income) might be a good hedge during an economic crisis but that hardly makes the leveraged bond strategy a hedge for all scenarios. When the interest rate environment changes and rates turn up there will be a large scale reversal of the billion$ if not trillions leveraged in the fixed income market to take advantage of the current low short term rates and to increase the returns above the meager interest rates earned through unleveraged fixed income investments. When that happens we will once again see what happens when a leveraged strategy is reversed en masse: large and volatile market moves. The leveraged bond strategy will turn out not to have been a stable or "hedged" strategy at all but rather simply a way to increase risk in search of higher returns. And Mr. Asness of AQR may once again find himself in a market environment his quantitative models didnt anticipate as everyone runs for the exits at the same time.

How Wall Street Makes Money Off You

Jason Zweig had a nice article on the inflated expected investment returns after inflation and taxes from investors and advisors

Robert Veres, editor of the Inside Information financial-planning newsletter, recently asked his subscribers to estimate long-term future stock returns after inflation, expenses and taxes, what I call a "net-net-net" return. Several dozen leading financial advisers responded. Although some didn't subtract taxes, the average answer was 6%. A few went as high as 9%.
We all should be so lucky. Historically, inflation has eaten away three percentage points of return a year. Investment expenses and taxes each have cut returns by roughly one to two percentage points a year. All told, those costs reduce annual returns by five to seven points.

So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

Even the biggest investors are too optimistic. David Salem is president of the Investment Fund for Foundations, which manages $8 billion for more than 700 nonprofits. Mr. Salem periodically asks trustees and investment officers of these charities to imagine they can swap all their assets in exchange for a contract that guarantees them a risk-free return for the next 50 years, while also satisfying their current spending needs. Then he asks them what minimal rate of return, after inflation and all fees, they would accept in such a swap.


I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.




Meanwhile, I asked Mr. Salem, who says he would swap at 5%, to see if he could get anyone on Wall Street to call his bluff. In exchange for a basket of 51% global stocks, 26% bonds, 13% cash and 5% each in commodities and real estate—much like a portfolio Mr. Salem oversees—the institutional trading desk at one major investment bank was willing to offer a guaranteed rate, after fees and inflation, of 1%.

All this suggests a useful reality check. If your financial planner says he can earn you 6% annually, net-net-net, tell him you'll take it, right now, upfront. In fact, tell him you'll take 5% and he can keep the difference. In exchange, you will sell him your entire portfolio at its current market value. You've just offered him the functional equivalent of what Wall Street calls a total-return swap.

Unless he's a fool or a crook, he probably will decline your offer. If he's honest, he should admit that he can't get sufficient returns to honor the swap.

So make him explain what rate he would be willing to pay if he actually had to execute a total return swap with you. That's the number you both should use to estimate the returns on your portfolio.

Now I don't have  problem with the 4% return number  possibly even lower depending on the tax situation.

But I also have a big problem with the wall street firms guarantee of 1% as it's best offer. Well I would hesitate to use the word crook I would certainly say that is a ripoff. The trading desk could turn around buy a 20 year tip to get an inflation protected return of 1.96% and pocket the difference for a risk free profit for at least 20 years.

oftentimes that's how wall street makes it's money. The trading desks scour the worlds markets for a risk free arbitrage of a fee basis points (.01) while the sales desks find client deals that generate 25 or 30 times to generate that return.

It's almost always better and cheaper to go straight to the market ( in this case buying a tip bond even direct from the govt for no commission) rather than buying a "package" from the wall street firms. You pay big time for the wrapping .

Blogging From The Inside Exchange Traded Funds(ETFS) Conference

I'm attending the large exchange traded funds conference in freezing (in the thirtes at nightnight)BocaRaton. Some of the stuff being presened was a bit scary to me: market timing systems with exponential moving averages making use of option selling,leveraged etfs and etfs that are devoted
to tiny slices of the market. Funny how the eternal "search for alpha" through market timing or security selection has spread to a part of the investing universe that was originally touted as a low cost, tax efficient way to gain exposure to broad asset classes for long term investors.

To the credit of my financial advisor colleagues I think most of them weren't buying what some of the presenters and vendors were selling. The majority raised their hands at the "is buy and hold dead" presentation indicating that they did not at all agree with that proposition. The presentations with elaborate trading systems seemed to get a skeptical response. And the session on gold was sparsely attended (but maybe that was because it was from 5 -6 pm and the cocktail party opened up around 6).

The areas where advisors seemed to have the most interest in adding to their allocations were in commodities and emerging markets, areas where I have had a good sized investment allocating for several years.

As I walked down the aisles of booths of the various etf providers I remarked that the only thing that seemed to be missing from the etf universe was an etf devoted entirely to the stocks of a single state. Reviewing some of the materials I received at the conference, I discovered that I was wrong...such an etf already exists. The OOK Oklahoma exchange traded fund:

The Fund invests in a portfolio of securities that represents a benchmark index of publicly traded Oklahoma-based companies that have their headquarters or principal place of business in Oklahoma. For more information, see our literature. The expense ratio is .20%.

While I am certainly skeptical that this constitutes an asset class, I do give them credit for keeping the expense ration low. The only possible purpose I could see for this type of instrument (and actually a quite valid one) would be for pension funds or endowments domiciled in the state that wanted to concentrate a portion of their assets exclusively to home state company stocks.