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The Best And Worst Of January: Multialternative Funds

Multialternative mutual funds and ETFs averaged losses of 1.60% in January, bringing their average one-year returns through the end of the month to -4.23%. Over the longer three- and five-year periods, multialternative funds have generated positive annualized returns, but at just +0.87% (three-year) and +1.66% (five-year), those returns have delivered negative alpha of 0.81 and 0.99, respectively, relative to Morningstar’s long-only Moderate Target Risk Index. As a whole, the category is host to 163 funds with combined assets of $62.5 billion. At $8.9 billion, the John Hancock Global Absolute Return Strategies Fund (MUTF: JHAIX ) is the largest fund in the category with a 14.2% market share, while the top 10 funds hold a total of $31.7 billion in assets – just over 50% of the category’s total assets. Top Performers in January January’s top-performing multialternative fund was able to generate big gains of 7%, while the second- and third best funds added between 2-3%. The three best-performing multialternative funds in January were: CMG Global Macro Strategy Fund (MUTF: PEGAX ) Absolute Strategies Fund (MUTF: ASFIX ) Vanguard Alternative Strategies Fund (MUTF: VASFX ) PEGAX, the top-performing fund of January, only launched in December 2015. In its first full calendar month, PEGAX returned an impressive +7.00%. According to Morningstar, $10,000 invested in the fund at its inception would have grown by $120 as of February 17 – not bad for just over two months. ASFIX (one of the oldest funds in the category) and VASFX produced gains of 2.87% and 2.83%, respectively, in what was a volatile January for the markets. Of the two funds, only ASFIX has been trading at least a year, and it returned +0.31% for the 12 months ending January 31. The fund’s one-year alpha and beta numbers were -2.25% and -0.65 (relative to the Morningstar Moderate Target Risk Index), through that date, with a Sharpe ratio of 0.07 and volatility of 5.49%. These numbers compare somewhat favorably to the category averages of -2.29%, 0.49, -0.82, and 5.76%. Worst Performers in January While the bottom three funds struggled as equity markets sold off in January, there is a silver lining – the month’s worst-performing fund was solidly in the black for the year ending January 31. The three worst-performing multialternative funds in January were: Catalyst Macro Strategy Fund (MUTF: MCXAX ) Quantified STF Fund (MUTF: QSTAX ) Tocqueville Alternative Strategies Fund (MUTF: TALSX ) Although MCXAX was January’s worst-performing fund by a long shot at -10.24%, the fund was actually the category’s top performer for the year ending January 31, with gains of 32.05%! With a beta of 2.71 to the Morningstar Moderate Target Risk Index, these one-year gains produced an alpha of 42.08% and a Sharpe ratio of 1.19. However, volatility came in at a whopping 26.03% – numbers that are somewhat reminiscent of Barry Bonds’ late-career stats. QSTAX saw its shares fall by 8.05% in January. The fund, which only launched in November 2015, doesn’t have a long enough track record for further analysis. Finally, TALSX was the third-worst performing multialternative fund in January, with one-month losses of 6.53%. For the year ending January 31, TALSX lost 9.45%, thanks to an alpha of -5.30%. Its beta over the time period was 1.05, while its one-year Sharpe ratio stood at -1.00, and its annual volatility was 9.53%. Past performance does not necessarily predict future results. Jason Seagraves contributed to this article.

Black-Scholes Pricing Model: Is The Hedging Argument Correct?

Black-Scholes Pricing Model: Is the Hedging Argument Correct? Preface Many are familiar with the works of Myron Scholes and Fisher Black in the late 1970s. Their contributions revolutionized the way we price options. Out of the many sections of their proof, the most interesting one in my opinion is the hedging argument given midway through the paper. The reason for which I find it so intriguing is due to the fact that it is the one section that is criticized the most. This leads us to a now popularized question, is such argument valid? Flashback Time As we pull out the proof written more than four decades ago, we notice that the traditional Black-Scholes hedging argument strictly assumes that: markets are frictionless, there is no arbitrage, there is a constant interest rate denoted as “r”, no dividends are paid out and that the stock price process respects the Geometric Brownian Motion. Let’s not forget that GBM (Geometric Brownian Motion) is a continuous time-stochastic process that models stock prices in the Black Scholes Model and other similar works. Click to enlarge If we denote the following as a European Call Price process: We must then further assume the following: As being in conjunction with some “C^2,1″ function C (S, t). When applying Itô’s Lemma we observe the following: Click to enlarge Let us also not forget that Itô’s Lemma is an identity to find the differential of a time-dependent function of a stochastic process. Now let’s consider a portfolio with the goal of long one call and short the following shares. (The goal is therefore what the portfolio consequently consists of.) If we short shares , then we must presume the following: By extracting the textbook argument we can observe the following steps: STEP 1. (**Highlighted**) STEP 2. Click to enlarge STEP 3. Click to enlarge Recalling that arbitrage is not part of the environment of the model we may equate coefficients on ” dt” yields the Black Scholes PDE. (We don’t need to go as far as to solve PDE) Click to enlarge This brings to mind a fascinating question, was the previously highlighted step (Step 1) correct? Gains Process Solution? Let’s remember that the tradition argument that if: Then: Although this seems appropriate, if we integrate by parts, we are then required to obtain the second equation as: Click to enlarge In order to maintain the strategy, two terms must be added representing additional investment. Both terms are differentials processes which have unbounded variation. We therefore cannot claim that ” dHt” is riskless. Since the math to find PDE takes too long I referred to Peter Carr’s solution to this problem in his 1999 paper discussing the proposed question. Carr had found that by doing the math right, PDE could not be found. Carr as well as many other critics, use this position in order to claims that perhaps the Black Scholes Model is wrong. The popular belief is that if the result is right, but the derivation is wrong, then the argument cannot stand. Many have proposed however, that it is possible to derive PDE by a more complicated means and achieve “tenure” therefore making the argument safe from derivations. Although this seems like a solution we must not forget that there are some that believe the contrary. Others have argued that the derivation is indeed correct since the number of shares held is referred to being “instantaneously constant”. (Sort of like instantaneous speed or velocity) In the eyes of mathematicians this two sided argument is difficult since the total variation of the number of shares held by any finite time interval must be in fact infinite. From Carr’s response, it can actually be observed that the number of shares is changing so fast that the ordinary rules of calculus do not apply. (Crazy Right?) So Is the Derivation Right..? No, well kinda… I believe that the derivation is in fact wrong since it is only correct up to some discrepancy or “typo”. If we assume the hedge portfolio value at time ” t” represented by: Then the gain “gHt” in the hedge portfolio is observed as: Click to enlarge It can be thought that “gHt” is riskless and therefore should grow at the risk-free rate in order to cancel out arbitrage. (Risk Free Rate is usually US Treasury Bill Yield) In Carr’s examples, equating coefficients on “dt” does in fact yield the Black Scholes PDE. To make the theoretical world “error free” for derivatives, the above argument replaces the need of computing a total derivative with the financial operation of determining a gain. The portfolio in question of an option and a stock is not self-financing. This is like the positions with regard to riskless assets. Essentially by showing that the gains between two non-self-financing strategies are always equal under no arbitrage, the derivative value of the security can be determined. So why say no? I believe that the solution does bring validity but also brings forward inconsistency. This inefficient manner of providing the solution takes away from the integrity of the model. I do not disagree with the hedging argument, I simply criticise the need for extra material to prove a factor that should be safeguarded in pricing models such as BSM. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Fixed Income – Now Is Not The Time

The Seeking Alpha ETF Investing Guide I recently reviewed the Seeking Alpha Investing Guide and decided to allocate part of my portfolio to a core portfolio of ETFs, similar to that suggested by the guide. I do not intend to completely switch course from my current allocation but to set up a separate core portfolio of ETFs and to allocate a majority of my investments to this Core ETF portfolio over time. After reviewing the investing guide, I drafted a procedure for implementing the suggestions of the guide. Currently, I am reviewing each of the suggested ETFs to determine which to buy. Readers that have read the articles on the first five recommended ETFs are aware that I plan to invest in the sectors that they represent. This article focuses on the three recommended ETFs from the fixed income portion of the Core ETF portfolio: iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) PowerShares 1-30 Laddered Treasury Portfolio ETF (NYSEARCA: PLW ) Schwab U.S. TIPS ETF (NYSEARCA: SCHP ) At this point, I am not inclined to invest in these ETFs, or the fixed income sectors these represent. I expect to keep funds I have allocated for this portion of my portfolio, invested in shorter-term bank certificates of deposit (cd’s) that offer similar interest rates with what I believe is far less risk of capital loss. Investment synopsis of the three fixed income funds The iShares iBoxx $ Investment Grade Corporate Bond ETF seeks to track the investment results of an index composed of U.S. dollar-denominated, investment grade corporate bonds. LQD provides exposure to a broad range of over 1000 U.S. investment grade corporate bonds. LQD can be used by investors seeking stability and income. The PowerShares 1-30 Laddered Treasury Portfolio is based on the Ryan/NASDAQ U.S. 1-30 Year Treasury Laddered Index. The Fund will normally invest at least 90% of its total assets in securities that comprise the Index. The Index measures the potential returns of the U.S. Treasury yield curve based on approximately 30 equally weighted U.S. Treasury issues with fixed coupons, scheduled to mature in a proportional, annual sequential (“laddered”) structure. The Schwab U.S. TIPS ETF goal is to track as closely as possible, before fees and expenses, the price and yield performance of the Barclays U.S. Treasury Inflation Protected Securities (( OTC:TIPS )) Index (Series L). SCHP provides a convenient, low-cost way to capture the performance of U.S. Treasury Inflation Protected Securities. SCHP provides exposure to a portfolio of treasury securities designed to offer protection from the negative impact of inflation while assuming exposure to interest rate risk. US treasury 10 year interest rate chart – 1962 to present Click to enlarge Source: Yahoo Finance (2/13/2016) The chart above shows US treasury 10 year interest rates since 1962. After peaking in 1981, interest rates have fallen steadily to their current rate of 1.75%. Interest rates were slightly lower for a short period in 2012 but other than that, they are at the lowest point over the 50 plus years shown. While I have felt the same way for some time, as interest rates have continued to fall, I would not be comfortable investing in medium or long-term bonds at current interest rates. In the past, I have found that when I make investments that I am not comfortable with, I have a very hard time holding them. Performance of LQD, PLW and SCHP compared to the S&P 500 since June 2002 Click to enlarge Source: Yahoo Finance (2/13/2016) The chart above shows the performance of the three fixed income ETFs versus the S&P 500. LQD had the longest history going back to 2002 and over this time is up 11% versus the S&P up 103%. The chart does not include interest or dividends, which would improve the relative performance of the fixed income ETFs versus the S&P 500. Performance of LQD, PLW and SCHP compared to the S&P 500 – 5 year chart Click to enlarge Source: Yahoo Finance (2/13/2016) The chart above shows the performance of the three fixed income ETFs versus the S&P 500 over the last five years. Again the S&P 500 has outperformed the 3 fixed income ETFs and again this chart does not include interest or dividends, which would improve the relative performance of the fixed income ETFs versus the S&P 500. ETFs in the US corporate bond category ETFs in the US treasury bond broad duration category ETFs in the US treasury inflation protected category Source: Seeking Alpha (as of 2/13/2016) Above are lists of the top 10 fixed income ETFs in each of the categories represented by the three recommended ETFs. Each category is listed by assets under management (AUM). As the tables show, there are a number of alternatives that interested investors can consider in each category, except the “treasury bond broad duration” category which only lists 2 ETFs on Seeking Alpha’s ETF Hub. Fund characteristics iShares iBoxx $ Investment Grade Corporate Bond ETF PowerShares 1-30 Laddered Treasury Portfolio ETF Schwab U.S. TIPS ETF Weighted average duration (years) 7.98 10.34 7.5 Weighted average maturity (years) 12.28 15.84 8.3 SEC yield (%) 3.73 2.49 0.02 Expense ratio (%) 0.15 0.25 0.07 Source: iShares by BlackRock, Powershares and Schwab (as of 12/31/2015) The fund characteristics are shown in the table above. I consider these characteristics versus a bank certificate of deposit (cd). Bankrate.com currently shows a one year cd at 1.30% and a five year cd at 2.27%. I do not feel that the potential yield improvement justifies the additional risk associated with the additional time to maturity, duration and the default risk of the corporate bonds. Other investors may be in a different position and see this differently. Conclusion Readers that have read the articles reviewing the first five recommended ETFs from Seeking Alpha’s ETF Investment Guide are aware that I plan to invest in the sectors that these ETFs represent, either in the recommended ETF or a very similar ETF. I do not feel the same way about the recommended fixed income ETFs, iShares iBoxx $ Investment Grade Corporate Bond ETF, PowerShares 1-30 Laddered Treasury Portfolio ETF and Schwab U.S. TIPS ETF. After peaking in 1981, US ten year treasury bond interest rates have fallen steadily to their current rate of 1.75%. Although others may feel differently, I would not be comfortable investing in ETFs made up of medium or long-term bonds at current interest rates. In the past, I have found that when I make investments that I am not comfortable with, I have a very hard time holding them. At this point, I am not inclined to invest in the three recommended fixed income sectors or ETFs: iShares iBoxx $ Investment Grade Corporate Bond ETF PowerShares 1-30 Laddered Treasury Portfolio ETF Schwab U.S. TIPS ETF I expect to keep funds I have allocated for this portion of my core ETF portfolio, invested in shorter-term bank certificates of deposit (cd’s) that offer similar interest rates with what I believe is far less risk of capital loss. I expect to review this periodically and consider investing in these ETFs and sectors when long-term interest rates have increased from current levels. Addendum Seeking Alpha’s Investment Guide Core ETF Portfolio ETF Ticker Fund Name Fund Description Expense Ratio VOO Vanguard S&P 500 ETF Large cap US stocks 0.05% IJH iShares Core S&P Mid Cap ETF Mid cap US stocks 0.12% VTWO Vanguard Russell 2000 ETF Small cap US stocks 0.15% IEFA iShares Core MSCI EAFE ETF Multi cap foreign developed market stocks 0.12% IEMG iShares Core MSCI Emerging Markets ETF Multi cap emerging market stocks 0.18% LQD iShares iBoxx $ Investment Grade Corporate Bond ETF US investment grade corporate bonds 0.15% PLW PowerShares 1-30 Laddered Treasury Portfolio ETF US Treasuries 0.25% SCHP Schwab U.S. TIPS ETF US TIPS 0.07% VNQ Vanguard REIT Index ETF US REITs 0.10% DBC PowerShares DB Commodity Index Tracking ETF Broad commodities 0.85% Simply Investing – Philosophy Establishing a core portfolio in well-diversified, low expense ETFs, held for the long term, is a good idea for most all investors. The core of a small portfolio can start off as simple as one well diversified global ETF with a low expense ratio, like Vanguard Total World Stock ETF (NYSEARCA: VT ). Typically, as the portfolio grows, the core of the portfolio would include exposure to the ten asset classes listed above. There are four steps needed to set up an efficient investment plan. The decisions and actions required to set up the plan and purchase the ETFs can be done in about 4 hours (see the further reading section below for more details): Decide on an asset allocation plan among the ETFs in the core portfolio. Open an online brokerage account with a linked online bank account. Determine if you will invest all your investment funds at once or over a period of time. Determine which investments to buy in your taxable and tax deferred accounts. The core ETF portfolio outlined above, after tax, should significantly outperform either individual stock picking or a portfolio managed by a financial advisor. Over the typical investors time horizon of 40+ years, the expected advantage of this core ETF portfolio is staggering. Investors that enjoy the investment analysis process and are willing to spend the time to analyze and invest in individual stocks or sectors can still do this. I believe, the majority of these investors should still set up a core ETF portfolio, but can allocate a small, fixed percentage of their portfolio to “edge” positions, which offer additional risk and opportunity. Further reading ETF Investing Guide – Written by Seeking Alpha’s Founder in 2006 is a great guide for setting up a portfolio of ETFs. Set Up A Core ETF Portfolio Now – Describes the four steps required to implement the suggestions in the ETF Investing Guide. The ETF Investing Guide is made up of 54 articles and takes some time to read and assimilate the information. This article condenses the information from the guide down to four steps that can be completed to set up a core ETF portfolio in around four hours. Disclosure: I am/we are long VT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.