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Thursday, May 27, 2010

Emerging Market Bonds During A Financial Crisis: As Expected Not a Safe Haven

I wrote on May 4 that I didnt find the case for holding emerging makerts bonds very convincing and that they would likely suffer during the crisis emanating out of Europe.

Bloomberg reports that yield spread over treasuries are widely across the board in the fixed income markets and emerging market bonds are not immune:

Bond Sales Fall to Least in Decade, Yields Soar: Credit Markets

....In emerging markets, yield spreads narrowed 22 basis points to 317 basis points, the least since May 19, according to JPMorgan Chase & Co.’s Emerging Market Bond index. The spread has widened from this year’s low of 230 on April 15.

"Common Sense" from James Stewart on Options..Not Exactly Sensible

James Stewart's Common Sense investing column in the WSJ is like a slow motion, low decibel version of Cramer's mad money. He throws out a group of buys and sells and never presents a scorecard of how his proposed trades do, except to mention some winners. But even the with the "winners" he never specifies dates and prices for his proposed portfolio changes.

As if that were not bad enough he often presents illogical rationale for his trades (again without details). In today's column we find the following about his stock option activity:

. I bought long-term Apple call options at only a modest premium to the current price,
the above is so vague as to be meaningless
and  he writes

I also raised some cash by selling some Google put options. This is the first time I've sold puts in over a year. (Selling puts means you agree to buy shares at the strike price if they're trading below that price when they expire.) It's a strategy I recommend when option prices are high,
Now anyone knowledgeable about options knows that "cheap" or "expensive"  is only relevant in terms of the implied volatility of the options.

Stewart didnt give details of his trades (of course) but

the January 2011 apple options are trading at an implied volatility of close to 42.

The short term june 2010 google options have a volatility of 34%

So it would seem to me (and most options traders) that at first glance it seems Mr. Stewart bought the expensive options and sold the cheap ones.

In any case given that both goog and aapl have heavy weights in the nasdaq it seems highly unlikely that the options on aapl would be cheap at the same time google option prices are "high"

The implied volatility for the nasdaq (the nasdaq equivalent of the VIX) is the vxn. The volatility on the vxn is very close to that of apple and it is clearly at historically high levels. Where it will go from here is certainly an open question,

But one thing that is pretty sure to me:  the likelihood that options on apple "trade at a modest premium"  at the same time the prices on googl options are high under current market condiions is zero.

Monday, May 24, 2010

What Was That Famous Line From JP Morgan ?.....

When asked for his forecast for the stock prices his reply was "they will fluctuate".
Well I would add a bit to that forecast for the near future....they will fluctuate alot. Faced with this prospect and the ability for retail investors to buy volatility in one instrument (vxx and vzz) I would see that as a far more logical move than trying to pick bottoms or tops.Mr. Market is giving at this point that the beginning of summer will be quite interesting for investors.

From the WSJ:

The sudden downdraft in world markets demonstrates that, despite more than a year of stock recovery, investor confidence in the wake of the financial crisis remains uncommonly fragile.
Until a few weeks ago, the market seemed to be returning to a pre-crisis norm. Commonly watched gauges of investor anxiety had tumbled to levels seen before the crisis. Corporate profits and economic growth proved surprisingly resilient, quieting investor doubts about the rally's staying power.
But Europe's difficulties in resolving its debt problems, the "flash crash" of May 6 and the national debate over the proper role of the nation's top banks have again put investors on edge, reawakening the fear and anxiety of the financial crisis that were lurking just below the surface. The sudden surge in gauges like the Chicago Board Options Exchange's volatility index, a commonly used barometer of investor anxiety, and the sharp correction of major stock indexes showed just how nervous investors are.
That suggests that more volatility is in store and future stock gains could be harder to come by.


Another strong sign of investor anxiety lately is their return to options to hedge risk. In times of increased fear, investors buy put options, permitting them to sell shares at a prearranged price, which helps protect them from losses in the event that prices suddenly fall.
The CBOE's volatility index, or VIX, is a measure of options demand. On April 20, with stocks and investor confidence rising, the VIX finished the day at 15.73, down where it was before the 2008 financial crisis began in earnest.

Sunday, May 23, 2010

The Big Guys Are Still Fighting The Fiduciary Standard

I have written several times about the prospect of including the fiduciary standard as a standard for stockbrokers and insurance agents. Despite the senate passing the new law on financial services regulation the issue is still open as the House and Senate versions treat the issue differently. Kathy Kristof of the la times writes:

Two similar versions of financial reform — the one approved by the Senate on Thursday and the one passed by the House in December — must now be reconciled to create a final law.  ...

Now there's a last-ditch battle to determine whether the reform package ultimately will require all financial advisors to be fiduciaries, or trustees for their clients, as the House bill requires.....

When the Senate voted to cut off debate on financial reform Thursday, tough language demanding that all advisors be held to a high standard of trust was sidelined for a provision that would just have securities regulators "study" the issue. That would leave brokers and insurance agents able to continue with business as usual. 

Most individuals aren't aware of this issue and dont realize that registered investment advisors (like me) are held to fiduciary standards brokers and insurance agents aren't. As the same article notes;

This fiduciary provision is simple, says Bob Webster, a spokesman for the North American Securities Administrators Assn. It demands that financial advisors — regardless of whether they call themselves "wealth planners" or "investment specialists" — put their clients' interests ahead of their own.
If they have a conflict of interest, they have to disclose it. If they think an investment you own or a product they're selling isn't good for you, they have to say so.
You thought that was already true? Think again,.....
Kristof goes through a few myths used by the industry against the fiduciary standards and debunks them. Here's one

Myth: Imposing a fiduciary standard on all financial advisors would deny investors access to valued products and services.
Reality: Investment professionals could sell exactly the same products they sell now, but they would not be able to tell you that they were offering impartial advice when they were simply trying to sell a product that would earn them a commission......
Brokers and insurance agents take great pains to obscure the difference between advisors who must look out for your best interests and those who don't have to. That leaves investors learning the lesson of who they can trust too late — when they're already stuck with a high-cost, low-value product that enriched the advisor rather than the investor. It's time to stop calling salesmen advisors.

Why Does The Story Always Seem The Same ? (Hedge Funds Division)

I cannot count the number of times I have read about advisors who recommend the use of hedge funds in a portfolio because they are "uncorrelated" with the overall market and "because of their ability to go short can make money in a down market".

But it seems like the story is always like this one (below). With a few exceptions of course the overwhelming evidence is that hedge funds are highly correlated to overall market trends. In fact it seems that their years of outperformance vs the market are in years when the market goes up and vice versa. And that shouldnt really be surprising the funds specialize in taking higher risks than the market through leverage and concentrated bets on the riskiest parts of the market. Thus when the market hits a speed bump their positions get  hit hard.

Three clear conclusions:

1. Hedge funds are not an asset class they are a bet on an individual manager's ability to generate alpha

2. True alpha= excess returns on a risk adjusted basis is very very hard to generate on a consistent basis. Those hedgies that generate excess returns are largely not generating alpha they are taking additional risk relative to the market with leverage and concentrations in higly volatile sectors. Add in the lack of liquidity vs investments like listed etfs and the case for hedge funds diminishes future. A true evaluation must adjusted for both risk and lower liquidity.

3. Just when an investor needs diversification most....during market crises hedge funds provide little of it.

from the FT:

Hedge funds hit by May volatility

By Sam Jones, Hedge Funds Correspondent
Published: May 17 2010 03:00 | Last updated: May 17 2010 03:00

Some of the world's biggest hedge funds have suffered significant losses this month after high levels of volatility across markets and the shortlived stock market plunge in New York combined to wipe billions from portfolios.
Losses in the first week of May alone erased all gains made so far this year for some managers, according to investors who spoke to the Financial Times.
Large losses in a single week are not unusual for hedge funds, which typically aim to outperform markets and cut volatility, but those this month have come as a stark reminder to many of the continuing uncertainty over the economic recovery.

Monday, May 17, 2010

Now That We Understand A Bit More About VIX, VIX Futures VXX and VXZ (from the last post) How Best to Use VXX and VXN

Whar are the implications for the market outlook of the analysis in the previous blog for the "real world" of the markets:

It seems the market anticipates near term volatility no doubt on the downside in particular.

As for those watching the vix, vxx and vxz:

The period since the introduction of the vxx have no doubt been extremely painful and frustrating for those that held it. Since the vxx represents the near term future and the contango was very large the vxx suffered large losses due to the cost of rolling futures contracts as they expired. Hence the sharp decline in the vxx far more extreme than the cash index. As for the vxz the losses were less extreme becuase of the less extreme curve between the mid date futures it represents and the less frequent roll trades.

But judging by much analysis I can have seen people have thrown in the towel on the vxx based on the short time period since the instrument has started trading. As seen in the table above as the vix increases to extreme levels the curve of term strucutre fkips, In other words the holder of the vix gets an extra boost in return just when he wants the hedge to be most effective.

Effectively the time decay of option premia hurt the vxx far more than the vxz. And the vxx is more sensitive to changes in the vix than is the vxz.

This differential means that the vxx is far more sensitive to changes in the vix than the vxz. The "hedge ratio" ration of price change in the etn relative to change in the far higher for vxx to vxz.

As volatility and the vix increased massively over recent trading days this was readily apparent the long suffering vxx holder saw their positions increase a multiple of the vxz and a large multiple of the actual volatility in the s+p 500 and by extension the global equity markets. Those looking for a 1:1 movement between the vix and one of the etns were disappointed but they were looking for the wrong result. The etns are linked to the future not to the vix which is an index and cannot be traded.

The correct way to look at these instruments is either as a hedge of a long equity position or a trade.  Since volatility is more extremen on the downside, the vxx or vxz position would offset those losses  And the instruments performed extremely well  the vxx for instance on friday moved  the percentage move in the sp 500, the vxz moved . Furthermore with the flip in the futures curve from contango to backwardazation the vxx will likely suffer little or no loss when rolling contracts/

So what is the bottom line for use of the vxx and vxz:

They should be viewed as a way to offset the actual volatility of the S+P 500 either as a trade or a hedge.

Traders should look to the vxx which has a higher leverage to the underlying moves but a slow market will translated to a far steeper decline in value. The volatility of volatiliy is far higher for the vxx. But the leverage of the vxx is quite large recently it moved 4-5x the move in the sp 500

Those looking for a longer term hedging vehicle should look to the vxz. Recently it moved around 2x the move in the sp 500.

Using the above numbers one could argue that a 20=25% position in vxx would offset all of the loss on a stock portfolio during turbulent times. For vxz it would be closer to 50%.

This instrument has an  added benefti. In a turbulent down market we have observed two things:

volatility spikes increasing the leverage of these instruments
Among equtiies diversification becomes weaker and "the only thing that goes up in a down market is correlation". So these instruments provide a hedge (although of course of not identical efficacy ) of the non US parts of an equity portfolio as well as the small cap US despite the fact the sp 500 is large cap US stocks

Here are 3 mos graphs of the vxx(top) and vxz note how painful the futures roll has been for longer term holders of the vxx while recently the market has been more favorable to vxx over vxz holders.

So what would be the optinal strategy for those that want to hold a black swan hedge in their portfolio ? A longer term position in the vxz an addition of vxx position or a partial swap from vxz to vxx in anticipation of higher volatility in the market and a reversal of the position during a time of market stability. Of course the likelihood of getting that timing right is as great as the likelihood of timing any other market. But a mix of a larger position in vxz combined with a smaller proportion of vxx probably the best approach with the caveat to avoid the vxx completely when the futures mkt is in deep contango.

The VIX Term Structure and What it Says About Future Volatilty...and That Black Swan Hedge

Judging by the CBOE website there is considerable interest in the term structure of vix futures measured as the difference between near term and further out futures on the vix and also the realtionship of futures to the cash vix. This can be a premium (contango) or discount backwardization, In fact there seems to be dispute even as to how to interpret that curve as the market predictor of future volatility.

A presentation on this subject on the cboe website they present a contrasting view of option expert and author Lawrence McMillan who sees an uupward sloping curve as a portent of high future volatility and that of "traders" who hold the opposite view. Based on my observation of market data, my experience in the currency options market and my inclination to follow the money rather than the analysis on paper I go with the view of the traders.

My reasoning is as follows. First off it is important to know that the vix itself is not a commodity that can be traded it is really what I would call a "plug number" or the calculated implied volatilty of the near dated S+P options. Without getting into a detailed explanation of the calculation (you can find that here) suffice it to say that if one knows the price of the option, the strike price of the option, the days to maturity and short term interest rates one can calculate the "implied volatility of options". Since professional market makers in options can (with limitations change the directional exposure of any option through reversals and conversions they are trading implied volatility).

The enemy of an option holdesr is a dead market. If the market is devoid of volatility, the option holder's positions will not  increase in value and the time decay of the options will be a slow bleed. Conversely the trader holding a short option position makes a bit of profit each day through time decay  in a dead market. Add to this the lack of  demand from directional option players in a dead market.  Since the time decay of short dated options is higher than that of long dated options the selling is more pronounced in the short dated options this is reflected in the vix and in the short dated futures hence contango  (short dated futures at a discount to longer dated).

When the market heats up two things happern those with short options scramble to reduce their risk of their short options moving into the money.  If the expectation is for a short term boost in volatility the first move is to buy the cheapest options  that are most sensitive to movements of the underlying (pushing the vix, a calculated number based on near term options) and to push near term futures at a premium to the longer term futures =  backwardization in the futures.

The cboe has some data on the curve  based on the differential between the cash vix and the futures, the direction of that differential is usually the same as the shape futures curve as well as the spx itself. Sharp downmoves in the lead to the vix trading at a premium to the futures (and generally the futures curve going into backwardation. The chart of the fall 2008 market collapse period can be compared to the middle of 2009 and the mkt recovery. And since extremes of volatility coincide with sharp market declines it is not surprising to see the pattern in this chart from fall of 2008 of vix cash vx futures.

The cboe website also has data for  for the relationship between the cash vix the futures and the futures curve . Here is a great table. The higher the vix the deeper the backwardation and vice verssa. Not surprisingly traders play this spread buying the near date and selling the further date in anticipation of high volatility and reversing the position when the outlook changes.

Average Realized VIX Spreads 1990-2003
Spot VIXSpot to 1 Month 1 to 2 months 2 to 3 months
15 to 20 4.02 1.64 1.74
20 to 25 0.92 0.85 0.25
25 to 30 -0.96 -1.24 -0.48
30 to 35 -3.23 -2.88 -1.57
35 to 40 -4.63 -2.94 -2.77
40 to 45 -9.95 -4.11 -2.33

The pattern was born out in the recent market .Here are 1 to 2 month spreads around the flash crash date (below). The next post will comment on how to use this information in hedging and trading..
29-Apr 1.99
7-May -6.05
14-May     0.71  

I Think We Have Seen This Movie Before

 Although we may not be there yet, according to this analysis  things are starting to look very familiar: Deja Vu all over again ?

Large Market Selloff
Sellloff instensified by leveraged investments, computerized trading and liquidation of hedge funds
All "risk assets" move down simultaneously: US across the board, commodities, developed and emerging market stocks and bonds
In the fixed income area a flight to quality with a large increase in spreads over treasuries for investment grade and high yield corporate bonds
Actual volaitility (VIX) and vix futures move up to extreme levels

The rational response for investors (as opposed to traders)

During the early phases purchase volatility through futures options, vxx or vxz etns. Resist temptation to trade the move by selling off long term positions, shorting or attempting to pick bottoms in commodities or equities.

During later stages monitor fixed income spreads. In 2008 high yield bonds reached a spread of 2000 basis points over treasuries vs a  long term average closer to 500 bp. High grade corporates exceeded 500 bp over treasury when their long term average is well below 100 bp.

These levels are clearly "overshoots" from fair value and at those extreme levels the risk/return in favor of high historic yields and capital gains are skewed in favor of the buyer. Since the default rate factored into such yields is way in excess of a rational expectation of actual defaults, purchasing bonds at such levels is far less risky than trying to pick a bottom for stocks. The lower risk move would be to make purchases as spreads begin to narrow rather than trying to pick an absolute top. Long term investors are likely to be awarded for their discipline and patience in making bond purchases in such market conditions,

Last time this movie played here is what high yield spreads did as stocks tumbled (hats off to bespoke investments)

Thursday, May 13, 2010

Pardon Me If I am a Bit Provincial Today

Pretty Impressive Achievements for a tiny country of 6 million:

Israel etf (symbol eis)  picture above since inception. The market is one of the first if not the first to recover to pre Lehman collapse levels


Israeli Firms Gird for Their Emergence

TEL AVIV—Israeli companies are scrambling to compete with the big boys for international investment dollars, ahead of the reclassification of Israel later this month from emerging to developed market by the influential indexing firm MSCI Inc.


Israel Will Join Economic Group of Developed Nations


Wednesday, May 12, 2010

It Seems the Quants Have Struck Again...Still No Explanation for The "Flash Crash"

We are just short of a week since the 8.5% intraday drop in the S+P 500  of May 6. We have yet to hear an explanation from regulators or exchanges As for the market the S+P 500 closed today virtually unchanged from the market open on that chaotic day. So does that mean the whole episode is just something to shrug ones shoulders over and move on.......I hardly think so.

I have no doubt the explanation lies in the complex of computerized,trading, derivative products and leveraged investment fund although I don't know the specific trigger and at this point doubt than anyone ever will..

 I am sure though that the mechanics and drivers (or programmers of the autopilot command) of these hyperactive trading vehicles are at the cockpit of machines that the regulators don't even have the faintest notion of. I am also sure that the folks using these tools don't really know how they will behave when they hit terrain ("market data points") that weren't considered when designing the machines and the autopilot system. 

It seems we have a constant cycle of  people far smarter than I  that get burned by designing leveraged trading strategies based on past data, lose massive sums when the proverbial "black swan hits. There are then the postmortems on how financial engineering "ain't physics" and there are no immutable rules. The quants may be chastened for a brief moment but they return to their engineering bench to build a better trading mousetrap and the cycle begins again.  

In the meantime markets, portfolios, corporations and entire economies suffer the blowback from these adventures in engineering.

Something is terribly broken. I am developing the concept of a "volatility tax" which is being taken out of returns to investors and cost of capital to corporations throught this activity (this is different than an actual tax levied by a govt ). I am not actually sure any entity is even profiting from this tax or whether it is just a "dead weight" cost to the economy. More on that later.

At the end of his book:

The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It     by Scott Patterson

video here interview with Patterson

In which he dissects how the quantitative traders took massive losses on their own books and contributed mightily to the market turmoil of 2008 he describes how they were less chastened than interested in moving onto the newest new thing, The new frontier for these guys was lighting fast high speed trading. Patterson points out in interviews that this was likely a new accident waiting to happen. That certainly seems to be the case


Computer Trading Is Eyed

Debate Turns to Absence of Circuit Breakers, Market Makers as Mystery Plunge Is Probed

Traders parsing the mystery of Thursday's stomach-churning stock-market plunge are focusing on whether rapid-fire computer trading, coupled with the market's complex trading systems, triggered a free fall that appears to have begun with an order to sell a single stock...
Over the past two decades, stock trading has gone from a relatively transparent network of human "market makers" executing buy and sell orders at a handful of exchanges to an almost entirely computer-driven system fragmented among dozens of players. And regulators don't have the ability to directly monitor many of these new players.


The Quants' Computers All Sold At The Same Time

And in what may be the ultimate feedback loop some see the hedge fund connected with black swan guru Naseem Taleeb as responsible at least in part for last week's black swan 900 point drop in the dow.
I have no way to judge the impact of the specific trades but the scenario is  a not uncommon one to varying degrees and certainly played a role in the 1987 stock market crash with the impact of portfolio insurance.

Any time there is extreme price movement in the market those that are short derivative positions that are options or have options like characterstics need to sell (buy) into a declining (rising) market in order to hedge their short positions that are essentially puts (calls), this selling (buying) then can push the market down (up) further triggering more hedging orders and exacerbating the market move.

The phenomenon is well known the author calls it a tsunami of orders, It occurs in "mini" form in markets for various securities and futures particularly at the expiry of options when the underlying is trading very close to a price where there are large holdings of options at the same level (strike price close to market price at option expiry date)


Shortly after 2:15 p.m. Eastern time last Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.
On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.
The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.
Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market. The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.
Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders.
In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.
"Universa alone couldn't have caused the meltdown," said Mark Spitznagel, Universa's founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.

CNBC website today

Black Swan" author Naseem Taleb told CNBC he had no knowledge of a trade that may have caused last week's stock market meltdown even though he advises the hedge fund that is believed to have made it.
According to the Wall Street Journal, a hedge fund named Universa Investments made a $7.5 million options bet last Thursday afternoon that the S&P 500 Index would plunge to 800 by June. Regulators are examining whether that trade may have triggered the mysterious drop of nearly 1,000 points in the Dow Jones Industrial Average .
Taleb said in an intereview that he advises Universa but does not have specific knowledge of the firm's strategy. Taleb rose to prominence with his "Black Swan" book in 2007 that laid out the circumstances leading to the collapse of the financial system.
"I am in general a risk adviser to Universa," he said. "I don't know their positions, I'm not involved in trading."

Black Swan /Volatility Hedge Update

The strategy of buying volatility etns has worked well during the current downturn. Since april 30:

VXX short term vix futures etn +31.5% (top leftt chart)
VXZ meditum term futures vix etn +11.5% (top right)
vix index  +28.4% (below left)
s+p 500  -2.5% (below right)

Clearly the black swan hedge with the etns has worked well

A couple points of note

  • . A quick google for VXX will lead many articles decrying the vxx as a terrible instrument that doesnt give the holder benefit when volatility increases. They fixated on  recent  past performance, never a good practice in investing  An example of this is from an "expert" on etns and etfs at the "authoritative" index universe website  who wrote on april 26

But neither the ETNs nor the proposed ETFs will fully benefit fully from any rebound in the VIX. That’s because the market for volatility futures right now is already pricing in the likelihood that volatility will be higher tomorrow than it is today. The Spot VIX is currently trading at 16.62, while May futures are priced at 18.50. In order for VXX (which currently holds the May contract) to appreciate in value, spot VIX must rise above 18.50 next month. In other words, investors need an 11 percent increase in volatility next month just to break even!

It gets worse in July, where the futures are pricing in a VIX of 20.75.

Well the vix is at 28.32 , the vxx is at 25.63 and the long vxx position returned 37% in the 2 weeks since that post more than overecoming what he saw as the insurmountable premium between the spot index and the futures.  And that differential between the spot vix and the july futures (even worse)  that he pointed out on april 26 ? The market has now flipped with the cash vix at 28.32 and the july futures at 27.10 (more on that later)

Seems to me this writer and others missed the whole point of owning the vxx. It is something designed to make money in extreme market turbulence. Judging its efficacy and writing it off based on how it disappointed during a stable market is, to put it charitably premature. The instrument wasnt around during the fall of 2008 but imo it performed quite well during its first test in extreme market turbulence.

  •  The short term etn the vxx is more sensitive to changes in the and actual market volatility. It will generate a return that is a higher multiple of the decline in the stock market. It is a more leveraged hedge but it will also drop far more sharply in response to drops in the vix and lower actual volatility
  • . The vxz based on the medium terms futures is a less leveraged hedge it also drops in price slower in response to falls in actual volatility and the vix

  •  The above makes the vxx more of a short term play on volatility the vxz more of a longer term hedge agains the black swan. IMO under current conditions some of the vxx should be held in addition to the longer term vxz hedge position.

  •  One thing that has bedeviled holders of the vxx in the past has been the cost of the "roll " of the futures on the value of their position. This can bee seen by the steady decline in the value of the vxx far more than the underlying index the vix.

This is because the vixx represents a long position in the near dated vix futures. As the futures approach expiration the etn provider must sell the futures nearing expiration and buy the next date futures. For most of the history of the futures index the market has been in "contango" the near date futures traded at a discount to the futher out date makin the roll costly often in excess of 10%.

The chart below illustrates the difference between the may and june futures and reflects the patterns between near date and next date futures contracts. A positive number means the june futures costs more than the may futures, meaning that the "roll" selling the near futures and buying the next date resulted in a loss. This dragged down the value of the vxx contract. More data on this can be found a this paper from S+P here

Now look at what has happened in the last week. The further date futures had moved to a discount to the expiring future (june is chearper than may) this reflects high demand for near term futures. This is exactly what happened during the fall of 2008 (black swan event) when the near date futures reached a premium of 20% over the further out dates (see the s+p paper). A fellow blogger gives a good explanation of the roll factor here although i dont agree on his conclusion about not using the vxx

What it means for vxx holders is that they are no longer penalized each time the ertn provider must "roll" their futures position. In fact what had been a drag on performance may in fact add a bit to the returns of the contract. In any case it means there will not be as large disconnect between the changes in the value of the vix and the vxx.

It also means that those long the vxx going into an extreme period of actual and implied volatility get an extra boost to the appreciation of their position as the futures curve shifts to backwardation (near date premium to far date futures) instead of the opposite = cotango.

Interestingly this movement also belies the conclusions of many in the blogosphere argued against every owning the vxx. As volatility goes to extremes the futures curve flips yielding a bit of a windfall gain as the futures are rolled. In other words when things get bad for those short volatility either literally or methaphorically those already long through the etns reap the benefit. The same thing happened in the futures in the fall of 2008. But since this was before the advent of the vxx etn, it seems many analysts discounted this happening. It is a "black swan" in the volatility futures market to coincide with the "black swan "in the underlying market.

Thursday, May 6, 2010

Think the Growth of High Speed Electronic Trading and Derivatives Doesn't Increase Market Volatility....

think again. SPY one minute chart today

Emerging Markets Bonds....The Money Flows In : An Accident Ready to Happen

The Wsj has an article today

Emerging Markets' Low Yields Still Find Fans

Debt Interest Rates Plumb the Depths As Investors Flock

About the continued rush of investors into emerging markets bonds with the consequence that the countries in this category are able to borrow at rates that are extremely attractive for the issuers. For the investors not so much.

Some current yields on 10 year bonds mentioned in the article
Mexico and Turkey: 5.125%
Egypt 5.75%

10 yr US treasuries are at 3.55, Australia at 5.66

The highest on the list is Lithuania which is in the midst of Greeklike austerity measures: 7%

The emerging markets etf (EMB) yields 4.94%

I can't see how these investments offer poor relative returns to other bonds I dont like to use the word bubble but the word comes to mind.

The risk return on the emerging markets play: a small pickup in yield based on a bet that even with the crisis in europe emerging market economies will hold up well. From the article

Ripples from the European markets have spread this week, sending prices on emerging-market bonds lower. But many investors think the selloff will be short-lived unless the European situation grows much worse.
In the past, emerging markets have suffered worse than developed markets during financial crises. But that dynamic is changing, says Keith Gardner, head of the emerging-markets group at Western Asset Management in Pasadena, Calif. Emerging-market debt "is not immune to a global crisis," he says. However, thanks to their stronger fundamental outlooks, "they should perform much better than historically has been the case."

Yet the warning signs that this may not turn out to be the case are certainly around...even on the next page in the WSJ:

Another Reason for Trouble in Asia 

HONG KONG—Jitters over Europe's growing debt problems are adding to Asia's stock-market malaise, as investors wonder whether the region's surprisingly strong recovery has peaked already....

The contagion of Greece's problems to elsewhere in Europe could crimp trade with Asia. The weak euro already is making Asian goods more expensive in Europe. The euro has fallen 13% against the South Korean won this year, 11% against the Singapore dollar and 9.6% against the Chinese yuan, which tracks the U.S. dollar. Hong Kong and Singapore, both trading hubs, count euro-area exports as 13.2% and 11% of gross domestic product, respectively, according to Nomura economists. China's euro-area exports total 3.6% of GDP.
For now, a bigger concern is that Asia's future growth will slow as policy makers tighten the monetary screws. China has made several moves to cool its housing market. It restricted bank activity for the third time this year on Sunday by raising the percentage of deposits banks must hold against their loans.
At the same time, some early signs are showing that the recovery in Asia is beginning to pull back from its roaring postcrisis bounce over the past two quarters

Here are some alternatives in US $ etfs and their yields(all have durations considerably shorter than 10 years thus less interest rate risk):

High Yield: (JNK) 9.14
Inter Term Corporate (vcit) 4.62
Intermediate Term Govt (vgit) 2.52

A portfolio spllit equally among the 3 etfs above would carry a yield of  5.43. I certainly would rather hold that then the EMB.

I am of the view that one day moves may not be indicative of long term trends but on a day like today (May 6) the relative movements of securities is a good indication of correlations in crises and of relative riskiness.

So today's price movements may be instructive:

emb -4.51%
vcit +.27%
jnk -2.68%
vgit  +1.31%

and the "black swan" trades

vxz   +4.84%

Tuesday, May 4, 2010

Emerging Market Bonds During a European Economic Crisis (or pretty much any othe time)?....No Thanks

 Two major international bond managers have been touting their heavy weighting of emerging market bonds in their global bond portfolios. Count me as skeptical of using these as part of any investors bond asset allocation.

In a previous post I wrote about the Templeton bond fund, praised in the WSJ for "thining different" in the words of the iconic Apple computer commercial.

Pimco, the bond powerhouse has also been aggressively promoting a bond fund with a heavy allocation to emerging markets.

Pimco launched its Global Advantage Bond Fund this year based on the index it created in 2009. The fund is listed on their website as a core bond holding and has a 30% weighting in emerging markets markets.

In fact larger holdings in emerging markets has emerged (pun intended) as a key part of their fixed income strategy. The WSJ reported

my bolds my comments from here on in blue

Pacific Investment Management Co., the world's biggest bond-fund manager, is increasingly investing in emerging-market corporate debt, part of a broader move to ramp up exposure to the fastest growing economies in the world and assets with the highest returns.
Pimco's clients, including pensions funds and insurance companies that are often the slowest to warm to the developing world, have progressively expressed more interest in this group of bonds, said Ramin Toloui, an emerging market portfolio manager at Pimco's Newport Beach, Calif., office. He was speaking via telephone en route to Washington for the International Monetary Fund's spring meetings.
Pimco, a unit of Allianz SE, has overall identified emerging markets as a growing opportunity, and last month increased its benchmark Total Return mutual fund's exposure from 5% to 6%.
However, the launch of Pimco's Global Advantage Bond Index last year is indicative of how much Pimco thinks investors should be exposed, said Mr. Toloui.
That index has a 30% allocation in emerging markets, he said.
Pimco has a research paper that makes the argument for the high weighting emerging markets vs developed and thus using a gdp weighted as opposed to cap weighted index as the basis for a portfolio. The arguments are familiar by know: large budget deficits in the developed world, questions on sovereign creditworthiness in other words Greece(and spain and portugal)  are just the beginning .
And unlike the 1990s and early 2000s theconditions in the emerging world in terms of macro economic conditions are better. Fair enough if one is venturing into international bonds it makes sense to weigh emerging bonds more heavily than indicated by a cap weighted bond index.

Also not surprising Pimco is able to trot out data showing that a heavy weighting in emerging market bonds increases returns without increasing risk..

Just as might be the case for emerging market bonds, high yield bonds may at times provide higher returns than the holdings on the bucket/umbrella side of the portfolio. But when I manage portfolios I hardly look at that lower return as an opportunity loss. I would compare the emerging market bonds to the rest of the risk assets in terms of risk total return and the diversification they provided.

Furthermore in terms of rirks protection we know that in times of crisis all risk assets become correlated and moved down. We saw this with emerging market bonds and stocks in 2008. There is little doubt in my mind that if a major capital markets crisis occurred again emerging market sovereign debt will perform worse than tresury bills.

I think we have seen this before. Researchers give a strong case for emerging markets outperforming other parts of the world based on stronger fundamentals and assume that past data on correlations and risk and return that the portfolio with a heavy weight to emerging markets will behave in the futures as it did in the past.

In fact it is quite likely that if there is a severe crisis anywhere in the financial markets emerging markets fixed income will suffer along with the rest of the world. and that the only safe haven will be in US treasuries. It certainly seems that way based on the 2 most recent major crises,

In August 1988 Russia defaulted on its bonds but the contagion spread across emerging markets, Emerging markets bonds fell 28% US govt bonds +2.6%

In the most recent crisis with minimal fundamental problems in the developing world relative to the developed, Oct 2008 saw emerging bonds -14% the US aggregate bond index fell -.3%

In other words everything goes down in a down market except correlation...this holds for bonds and stocks.

In the wake of the 2008 crisis there has been alot of rethinking about portfolio theory and portfolio management and its limitations. Probably the most useful conclusion is as to the limit utility of diversification as commonly referred to in finance. Diversification comes from the low correlation of asset classes a measurement of how much assets/asset classes move togehter. According to theory adding assets with low correlation to each other to a portfolio offers the potential for increasing return without increasing risk. But experiences shows that it is very often not the case, particularly in times of financial stress.

Diversification is not the same as risk management. It is undeniable from looking at the data that correlations go up during sharp market declines. In other words the kind of diversification that one might hope for based on statistics with regard to correlation fades away just when one needs it the most. Mark Kritzman of MIT and Windward Capital has written about the Myth of Diversification. He has pointed out that most people in the real world look at "good correlation and bad correlation" good correlation being assets that offer protection during a down market and bad correlation assets that pull down returns when the overall market is rallying. He akins the conventional way of looking at risk management through correlation to someone putting their head in an oven and their feet in a bucket of ice in order to create a moderate body temperature.

I agree completely and therefore only view the safest fixed income strictly defined as tbill asn tips and a hedge with an asymmetic payoff such as long puts and long volatility as risk reducing diversifiers.

A portfolio with a high weighting of emerging market bonds certainly does not fall into this category it is simply adding to the risk asset side of the portfolio.

 I agree with most of the arguments for long term outperformance in the emerging markets and have positioned the equity allocation of my portfolios accordingly. But I dont find the argument for emerging market bonds as an addition or alternative particularly convincing. First of there is minimal debt to be had from some of the fastest growing emerging economies, judging by the list of countries in the FTs table of emerging markets Singapore, Hong Kong, China and India have minimal outstanding bonds. In fact despite all the publicity and literature surrounding the fund and the growing parts of the emerging economies a review of the portfolios holdings on the website shows less than 1% of holdiing in remimbi bonds, nothing from India, Singapore or Hong Kong (but plenty of holdings in Europe, Mexico and Brazil)..Obviously this is far different than the country exposure one would structure with equity etfs or even active funds if one's investing thesis woas to position to participate in the high economic growth in emerging markets and emerging asia in particular.

As a consequence of the fact that there are virtually no bonds to buy from the fastest growing emerging asian. For that reason the Pimco bond fund takes outright currency positions in order to get exposure to China , South Korea and Taiwan. The rationale is expressed below. But since the chinese currency is no freely exposed to market conditions the chinese yuan positions amounts to a bet on future government policy. Sorry but I would rather be directly exposed to the economy's growth through equities.

Pimco is pushing this idea of emerging market bonds across its products. Another fund the Pimco Unconstratined Bond Strategy which can hold up to 50% emerging markets also ventures into this area but winds up with slim pickings in emerging asia debt and instead looks to outright currency positions.

from Pimco:

On the currency front, we are long a basket of Asian currencies, anchored by the Chinese yuan and with satellite positions in the South Korea won and Taiwan dollar. We believe these regions’ currency appreciation is a natural response to the fundamental need of China to shift from an export-oriented toward a more consumer-led economy. The Asian region has fared relatively well recovering from the latest bouts of global recession, and has the resources, labor force and rising total factor productivity that we believe will lead to a currency correction. We also hold positions that may benefit from expected weakness in the British pound and euro currencies.

Secondly the yield spreads are so minimal as to offer extremely limited risk return vs US bonds the highest yielding asia bond was indonesia 1t less that 2% over treasuries ...and there is certainly potential for political instability there. I would much rather hold emerging market stocks for my emerging portfolio and  if I were to put any fixed income on the risk side of the asset allocation do it through a purchase of a liquid high yield US dollar instrument like the HYG with a yield differential of well over 4.5% over treasuries.

A bond fund is in fact a very poor way to try to get a benefit from the growth in emerging markets.

In my view the new  products that incorporate large allocations to emerging markets bonds are a classic case of a "product" that has to be "sold" as opposed to a financial instrument that actually makes asset allocation cheaper and better.

Interestingly in an interrview on the pimco website  Lisa Kim one of their managers states the following:

In thinking about where this strategy fits in an investor’s asset allocation, consider why investors buy bonds in the first place. Typically, they are looking for (1) capital preservation, (2) diversification from equities, (3) income, (4) liquidity and (5) impact mitigation from an economic downturn. A core fixed income strategy and the Unconstrained Bond Strategy should really be no different in how they address each of the first four concerns.
the manager furthermore argues that in an inflationary rising rate environment their fund would do better than a standard bond fund

My response to the Pimco manager would be "maybe yes and maybe no" especially since the investor has no idea what the fund owns at any given point in time.

On the other hand I love the economic/scientific term occam's razor thks to wikipedia for this 

law of economy or law of succinctness). When competing hypotheses are equal in other respects, the principle recommends selection of the hypothesis that introduces the fewest assumptions and postulates the fewest entities while still sufficiently answering the question.. 

So if I were to refer back to the quotation above from Ms. Kim on why investors hold bonds and would be faced with the choice of:

a. A pimco actively managed portfolio that could contain foreign currency, emerging market bonds, mortgage backed securities, corporate bonds, taxable munis like the Unconstrained Bond Fund, the Global Advantage Bond Fund or even the flagship Pimco Total Return Fund


b. a mix of tbills and US Tips

It seems pretty self evident where occam's razor would point me

Monday, May 3, 2010

Want German Bonds With That Greek Crisis....I Don't

Pimco guru Mohammed el Arian gives good overview of the Greek and European crisis in this week's Barrons:(my bolds , my comments in blue)

Barron'sThis week we saw Greece's credit rating cut to junk status, Portugal and Spain downgraded and the head of the OECD liken the debt crisis to the Ebola virus. What happens next?
El-Erian: This past week the market came under pressure from late sellers, people who recognized that Greece isn't interest-rate risk but a volatile credit risk and thus needed to trim positions. It blew out spreads significantly and made the market highly illiquid. That led to a scramble among the International Monetary Fund, the European Union and Greece, and we had the image of [IMF Chief] Dominique Strauss-Kahn and [European Central Bank President] Jean-Claude Trichet going to Germany, where all the decisions are being made, which was very reminiscent of [Federal Reserve Chairman Ben] Bernanke and [former Treasury Secretary Henry] Paulson going to Congress. We enter the weekend with the Germans considering how much of a bailout they can finance. I suspect that behind closed doors, the other question is how you involve the private sector, whether it's willing to buy new Greek bonds and treasury bills, or whether it's involuntary, where the private sector contributes not by putting in new money but by not being repaid. Nobody in Europe wants to talk openly about this. Greece isn't just a liquidity problem; it's a liquidity and solvency problem. Greece alone can't resolve its solvency issue. The longer the delay in putting together both domestic adjustment and external financing, the higher the probability of a debt restructuring.
It's important for investors to have Plan A and Plan B. Under Plan A, ultimately, the Germans will need to finance most of this large bailout package and cover Greece for two to three years. That would give a bid to risk assets. Under Plan B, the Germans will be reluctant to write large checks for so long that it would make restructuring a higher probability. This would shock the risk markets, spread the problem to European countries, contaminate European banks, reduce liquidity in the system. So you plan for both, scale your positions so they can adjust quickly to either scenario. The market on average has bet on Plan A.
The delay in solving Greece has disrupted Spain and Portugal. It's a real possibility that Spain and Portugal may need to receive a bailout from Germany. It's a low-probability scenario that Germany will sign up for that bailout, so that's why getting Greece right is so important. Otherwise, the number of attractive options for Europe diminishes. Germany is able to financially write these checks but unwilling to be the funder of a three-year bailout for these three countries.
If the issues for the peripheral European countries aren't resolved, it's a bigger problem for Europe-wide issues, including the euro. Next, you ask the question of what happens to the euro zone itself. What happens to the euro zone should be taken seriously as a risk scenario. This is about 10 steps away from what the market is willing to recognize.
For too long, markets have priced in what we called at Pimco an immaculate recovery for Greece -- this notion that the private sector would continue to buy into artificial growth and long-promised fiscal adjustment on the part of Greece and would provide so much financing that it would lower Greece's borrowing costs to such low levels that you could get both fiscal adjustment and growth. We sold Greek holdings early on and stayed on the sidelines rather than participate in the various bond issuances that Greece has made and that have subsequently gone down in value. 
El Arian notes that Pimco holds no positions bonds of Greece, Spain or Portugal

But interestingly later in the interview he states:(my bold)

What do you like these days in the emerging and developed markets?
At Pimco, we have been and are going up in the capital structure, migrating up the quality side in corporate paper. I like equity and credit exposure in Australia and Canada, interest-rate exposure in Germany. In the U.S. and U.K., I'd look to add inflation exposure on attractive pricing.
El Arian is responsible for managing far more money than me but I can't see how holding any German paper follows from the analysis he gave of the European situation. (top Pimco honcho also indicated a preference for German bonds in his april commentary) The only possible situation for holding German interest rate risk would be a bit of a perverse one: a massive decline in German growth and the need to bailout German banks would lead the ECB to flood the market with liquidity. Of course the consequences to the Euro would be dire leaving dollar based  investors in euro denominated paper with large currency losses. What are the prospects for a bank bailout in Germany ? the nyt gives an estimate of German exposure to the weaklings of Europe

German Banks Have Big Investment in Greece

April 28, 2010, 5:20 PM
There may be a good reason why German taxpayers are so unhappy about having to lend money to Greece. In effect, they already have. Germany’s financial institutions hold some 28 billion euros, or $37 billion, in Greek bonds, Barclays Capital estimates, extrapolating from International Monetary Fund data,  Jack Ewing of The New York Times reports from Frankfurt.
A quick survey of Germany’s largest banks on Wednesday indicates that probably half of that debt — rated “junk” by Standard & Poor’s since Tuesday — sits on the balance sheets of institutions that are owned or controlled by the government. The percentage could be much higher, but outsiders have no way of knowing for sure because bank regulators and many of the banks refuse to disclose precise numbers.
Germany’s existing exposure to Greek debt easily exceeds the 8.3 billion euros that the country would lend to Greece as part of a European Union plan to help the country avoid default on its debt — though not the 24 billion euros that may eventually be needed from Germany. Hypo Real Estate Group alone holds 7.9 billion euros worth of Greek debt. And, after a bailout last year, the taxpayers own Hypo Real Estate.
Germany’s direct exposure to Greek debt provides another reason  the country’s problems are very much Europe’s problems. “It’s not just a question of paying for Greece’s luxury pensions. There are intrinsically strong German interests as well,” said Alessandro Leipold, former acting director of the I.M.F.’s European Department.
In my view this peek into Pimco's thinking points out a more fundamental issue related to Pimco's active bond management and use of their funds.

But should one be venturing into non US and especially non dollar bonds at all? I don't think so. Pimcos fixed income managers are confined in their holdings to fixed income yet unrestricted within that category and as their largest fund title indicates they are looking for the greatest total return. But is that really the purpose of the bond part of most investors' portfolios ? I would argue no.

The fixed income portion of a portfolio consisting of equities, bonds and perhaps alternatives like commodities is to provide the anchor of a portfolio. I like very much Peter Stanyer's concept in his book of umbrellas and ..... To me this is the purpose of the bond part of the portfolio. Steady extremely low risk earnings with emphasis on capital preservation and tbills held for liquidity more than earnings.

The ideal holding for the umbrella part of the portfolio would be TIPS which carry US sovereign risk and no risk of loss of real return due to inflation.While in is true that perceptions of sovereign credit risk has declined I reject the idea that there is meaningful risk of a US bond default. If such an event would occur the magnitude of the financial crisis would make 2008 look mild and would leave no room to run for cover. Short term treasuries and highly rated investment grade bonds might be a part of the portfolio for the slightly adventurous.

 International bonds in my view belong on the other side of the asset  allocation that is in the risk asset section along with equities, reits and commodities. A good comparison would be with domestic high yield bonds which may have risk rather to yield characteristics that at time merit additions to a portfolio but they are not part of the bucket and umbrella part of the portfolio. Pimco's managers may be quite skilled at moving things around with freedom to roam anywhere around the world and around the the yield curve, credit spreads and types of issuers, But is that what one really wants for the defense side of ones portfolio in the bond allocation ?

Nevertheless Pimco promotes its flagship total return bond portfolio as a core fixed income holding and puts its new Global Advantage Bond Fund with a 30% allocation to emerging market bonds in the same category of core bond holding. I'll pass using those for that purpose.

 But it seems that some of my well known colleagues look at things differently. Here's the bond allocation from a firm highlighted in today's WSJ. I would say only the Pimco Low Duration fund provides anything clost to the "liquidity "bucket" or "umbrella" to withstand financial storms that I look for in my bond allocation

BONDS: There is a 36% allocation to bonds, primarily through bond powerhouse Pacific Investment Management Co., whose funds the advisers have used for more than a decade.
Mr. Voicu allocates 9% to Pimco Total Return, which primarily buys high-quality medium-term bonds, and 6% to Pimco Low Duration, which buys bonds of shorter maturities. The portfolio has two multisector funds that can buy various types of bonds, including risky low-quality bonds. They are Loomis Sayles Bond, at 4%, and Pimco Unconstrained Bond, at 9%. The portfolio's 8% foreign-bond allocation is in Pimco Emerging Local Bond, which buys medium-term bonds of governments and companies in developing countries.
Interestingly the same month end investing in funds section of the WSJ prevents a glowing review of another bond fund that I would never hold as part of my bond allocation for the same reasons outlined above.

Michael Hasenstab has led the Templeton Global Bond fund to the top of Morningstar Inc.'s world-bond category over the past decade. He got to No. 1 partly by saying no. No, that is, to strictly modeling his portfolio after a bond index, ...
Mr. Hasenstab is more than willing to own big slugs of bonds from countries that have virtually no representation in the fund's benchmark, the Citigroup World Government Bond Index, as long as they have strong fiscal policies and healthy economies. That's a move that in most fund companies would have marketing executives complaining about "style drift." For Mr. Hasenstab it has meant stakes in Brazil, Australia and South Korea.
I took a little peek under the hood of the fund  at the Franklin Templeton website and found a couple of things that caused me further pause. The fund carries a 4.25% initial sales charge and a .96% management fee. According to the website that chops the funds effective one year return from an impressive 26.23 to 20.89. Still very impressive but still, fees cut the net return by 1/4.

The fund's top ten holdings include Korea, Poland and Russia t fee and depending on share class a front end or deferred load, meaning the fund must outperform an index by more than 1.5% before yielding any net benefit to the investors. The fund also owns California munis, venezuelan and mexican govt paper.

A possible holding for people that believe in aggressive active management for part of their portfolio ? I guess so. But it is certainly not something for the bond part of any portfolio I would manage.