Tag Archives: cost

Tetraphase Pharma Offers A Lesson In Risk Management

Summary Limit sell orders wouldn’t have protected investors from Tetraphase Pharmaceutical’s 78% plunge after hours Tuesday. Two ways for investors to limit downside risk from stock plunges like this are diversification and hedging. We examine the pros and cons of both of those methods of risk management. Tetraphase Tanks After Hours Shares of Tetraphase Pharmaceuticals (NASDAQ: TTPH ) closed up 3.54% on Tuesday, to $44.78. Less than 40 minutes later, TTPH was trading for under $10 per share after hours, as the dramatic graph below from YCharts shows. (click to enlarge) What tanked the stock, as Seeking Alpha news editor Douglas House reported , was the failure of its leading drug candidate, a broad spectrum antibiotic called Eravacycline , in a stage 3 clinical trial versus another antibiotic called Levofloxacin in the treatment of complicated urinary tract infections. Limit Sell Orders Don’t Limit The Loss A painful lesson some Tetraphase longs may learn here is that limit sell orders don’t protect against these kinds of drops. Consider, for example, a hypothetical investor who owned Tetraphase on Tuesday and didn’t want to see his position value drop by more than 20%, so he set a limit sell order at $36. The problem with this sort of limit sell order is that it won’t get you out of the stock at $36 per share, if the stock never trades at that price on its way down. Whatever price the stock opens at the next day is the price an investor would be offered for selling the stock then. Two Ways To Limit Stock-Specific Risk Two ways to limit stock-specific risk of this kind are diversification and hedging. Both have their advantages and disadvantages. The big advantage of diversification is that it doesn’t cost much.[i] As the Nobel laureate economist Harry Markowitz famously put it, “diversification is the only free lunch”. If you owned Tetraphase as part of an equal-weighted portfolio of 20 stocks on Tuesday, the worst impact it could have on your portfolio value going forward would have been -5%, because it would have comprised 5% of your portfolio. Of course, the flip side to diversification is that if a particular stock does very well, its impact to your portfolio would be similarly limited. Diversification limits the harm caused by your worst investment, but it also limits the benefit provided by your best ones. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998, If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Unlike diversification, hedging allows you to concentrate your assets in a handful of securities you think will do best, because your downside is strictly limited. Consider, for example, hedging with put options. Put options (or, puts) are contracts which give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). An investor who owned 1,000 shares of Tetraphase on Tuesday and 10 put option contracts (each contract covers 100 shares) with strike prices at $40, would have been able to sell all of his Tetraphase shares for $40 on Wednesday, regardless of what price the stock was trading at then. The main drawback with hedging, though, is its cost. At Portfolio Armor , we look for optimal puts (as well as optimal collars) when hedging. Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. A Tetraphase investor scanning for optimal puts on Tuesday against a greater-than-20% drop over the next several months, would have gotten this message, The reason he would have seen that message is that the cost of protecting against a greater-than-20% drop on Tuesday was itself greater than 20% of position value. The smallest decline threshold against which it was possible to hedge TTPH over the same time frame with optimal puts on Tuesday was against a greater-than-27% drop, and, as the image below shows, the cost of doing so was prohibitively expensive – equivalent to nearly 27% of position value. Note that, in the image above, the “cap” field is blank. If an investor had entered a figure in that field, the app would have attempted to find an optimal collar to hedge Tetraphase. A collar is a type of hedge in which an investor buys a put option for protection, and, at the same time, sells a call option, which gives another investor the right to buy the security from him at a higher strike price, by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest price, while not capping your possible upside by more than you specify. In a nutshell, with a collar you may be able to reduce the cost of hedging, in return for giving up some possible upside. It was possible to hedge Tetraphase against a greater-than-20% drop over the next several months with an optimal collar on Tuesday, if an investor were willing to cap his possible upside over the same time frame at 20%. The cost of that protection would have been 8.26% of position value, which would still have been fairly pricey. Using Security Selection To Reduce Risk (and Hedging Costs) Another way to reduce risk, and to hedging costs, is to avoid stocks like Tetraphase in the first place. That may sound like hindsight at this point, but remember the hedging cost shown above was calculated using data from before the stock tanked. Hedging cost that high can be a red flag. By way of comparison, look what the cost of hedging Gilead Sciences (NASDAQ: GILD ) against the same percentage drop over the same time period with optimal puts was on Tuesday: As you can see at the bottom of the image above, Gilead cost 2.1% of position value to hedge. Tetraphase was 12.6x as expensive to hedge in the same manner. By limiting your portfolio to securities that are relatively inexpensive to hedge, you will end up avoiding some of the riskiest ones. How much should you be willing to spend to hedge? That depends, in part, on how high you estimate the potential return of your underlying securities. One approach is to calculate both hedging costs and potential returns for your best ideas, then, subtract the hedging costs from the potential returns, rank them by potential return net of hedging cost, and buy and hedge a handful of the highest ranked ones. That’s the essence of the hedged portfolio method, which we detailed in a recent article (“Keeping A Small Nest Egg From Cracking”). —————————————————————————– [i] To be precise, this isn’t quite true if you buy individual stocks rather than a low-cost index fund. All else equal, the more you diversify, the more trading costs you will incur. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

Crisis Alpha: Surprising Ways To Hedge Stock Portfolio Risk

By Wesley R. Gray Investing in the current environment is difficult. Most, if not all, asset classes have high nominal prices, suggesting low nominal expected returns. Not exactly exciting. And for many investors who are retired and/or have near-term liquidity needs, investing in equity exposures – while necessary to generate higher expected returns – also prevents many investors from sleeping at night! One solution to curb the risk of a massive market meltdown is to buy portfolio insurance. However, in a rational world, insurance contracts are expensive because they protect us when we need protection the most. Insurance has this pesky problem of charging a large premium for downside protection. For example, consider put options on the S&P 500 market index. If an investor wants to hedge against a 10% drawdown for a year, the cost (as of August 13, 2015) would be approximately 4% of the notional value to be hedged. So if you had a $1,000,000 stock portfolio and wanted to ensure the most you could lose was $100,000, the cost of that insurance for one year would be around $40,000. Clearly, buying portfolio insurance can be expensive. But what if we could identify unique assets where the cost of insurance was much lower? We’ve identified 3 candidates that may fit this profile: US Treasury Bonds Hedge Fund Factors Managed Futures We highlight some of the historical evidence of the abilities of these assets to provide portfolio insurance (they go way up, when stock markets go way down). Of course, past performance is no guarantee of future performance, and nobody can know what will happen in the future, but the results inspired us to dig a little deeper and think harder about our own portfolio construction efforts. 1. US Treasury Bonds The results below highlight the top 30 drawdowns in the S&P 500 Total Return Index from 1927 to 2013. Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Next to the S&P 500 return is the corresponding total return on the 10-Year (LTR) over the same drawdown period. Bottom line: When the market blows up, flight-to-quality 10-Years have done well. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 2. Hedge Fund Factors We examine 3 common hedge fund “factor” portfolios alongside the S&P 500 Index: S&P 500 = S&P 500 Total Return Index HML = The average of 2 value portfolios (small and large) minus the average return of two growth portfolios (again, small and large) MOM = The average of 2 high return portfolios (small and large) minus the average return of two low return portfolios (small and large) QMJ = The average of 2 high-quality portfolios (small and large) minus the average return of two low-quality portfolios (small and large) Results are gross of management fees and transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Data are from AQR and Ken French . Next to the S&P 500 return is the corresponding total return on hedge fund factors over the same drawdown period. Bottom line: When the market blows up, hedge fund factors have done well. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 3. Managed Futures Here we examine a chart from a white paper by the folks at AQR. The paper is called, “A Century of Evidence on Trend-Following Investing.” The trend-following concept analyzed can be considered a generic managed futures strategy. Bottom line: When the market blows up, trend-following managed futures have done well. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Conclusion Historically, Treasury Bonds, Hedge Fund Factors, and Managed Futures have all managed to act like portfolio insurance, even though they aren’t traditionally considered insurance assets. Will this pattern continue in the future? Who knows…and of course, that is the million dollar question… Let us know if you’ve seen other hidden portfolio insurance options out there. Please share ideas… Original Post

An ETF Leveraged Pairs Strategy That ‘Works’ (But Would Still Be A Terrible Investment)

Summary In general, shorting pairs of leveraged ETFs does not generate favourable returns. An exception to this is shorting the volatility future TVIX, XIV pair, with this giving seemingly excellent returns. But this strategy is not advised, with the investor effectively selling financial catastrophe insurance. The theory The core equation describing the expected return of a leveraged ETF is as follows: Here ‘underlying return’ is simply the return on the asset the ETF leverages, anything from SPY, industry-specific equity funds, VIX futures and various commodities. λ specifies the ETF’s leverage; typically this is -1 (i.e. inverse), 2 or sometimes 3. Finally, σ is the standard deviation of the underlying return. The equation can be split into two, showing the key drivers of the return: The return on the underlying, leveraged λ times: The decay from volatility: It is the second – volatility decay – term that generates much of the criticism of leveraged ETFs. It reduces the return unless the ETF is unlevered i.e. λ = 1 or has no volatility i.e. σ = 0. Its adverse impact increases with leverage and the volatility of the underlying. The practical reason for volatility decay is the ETF’s daily rebalancing: a, say, 10% fall in the underlying, followed by a 10% rise will leave the underlying unchanged but see a leveraged ETF lose money. A leveraged ETF’s return is, however, not necessarily negative. It depends on the balance between the underlying’s return and the volatility decay factor. For example, SPY – representing the S&P 500 – has a (conservative) expected return of, say, 6% p.a. and a standard deviation of, say, 20% p.a. Plugging these numbers into the above formula gives a long-run expected return of ~8% for a 2x leveraged SPY ETF. This is well below the naïve 2 x 6% = 12% expectation, but is an improvement on the unlevered 6%. It is nevertheless at the cost of more than proportionally increased volatility. The theory applied to shorting leveraged ETF pairs Moving on to this article’s main subject, shorting pairs of leveraged ETFs. Applying the equation to shorting a pair of ETFs with leverage λ and -λ: The next step needs some algebra. Take the above equation and expand out (using Taylor’s series), neglecting any term higher than order 2 (these terms will be small in comparison). Then with λ = 2: Examining this equation shows the return will be positive for realistic pairs of leveraged ETFs: an asset’s return standard deviation (σ) will be bigger than its expected return (U). By shorting a pair of ETFs with opposite leverage and the same underlying, the return of the underlying cancels out and does not impact the strategy’s result. The strategy instead collects the (on average) losses generated by the interaction of the asset’s volatility and the daily rebalancing. In practice: Shorting UPRO and SPXU These two ETFs are designed to give 3x and -3x the compounded daily return on the S&P 500. Shorting $100k of both gives the following return chart: …equating to a stable before cost return of ~2% p.a. Unfortunately, the after cost return is ~-5%! These costs are principally the cost of borrowing the shares to short. I have UPRO costing ~5% p.a. to borrow and SPXU ~3.5% p.a. Notwithstanding the theory above, the market is efficient and has reached such by increasing borrow costs to unusually high levels. Similar results occur for all – bar one – pairs of leveraged ETFs that I have examined. In practice: Shorting TVIX and XIV The exception are a couple of volatility ETFs, TVIX and XIV. TVIX is designed to return 2x the VIX futures short term index. XIV is designed to return -1x the same index. Because the fund’s leverages are not equal and opposite, this strategy involves shorting $2 of XIV for every $1 of TVIX. It results in the following return chart, for a $100k notional investment: After costs, it yields a return of ~10% p.a. with a Sharpe ratio of ~ 2 (compared to the S&P 500’s ~ 0.5). It is also possible to leverage this strategy further; as shown it starts at -$33k TVIX and -$67k XIV, but (if you have portfolio margin) your broker may allow multiples of these amounts. The strategy works because of the exceptionally high volatility of the underlying VIX futures, together with the ETF’s relatively large tracking errors. The large drawdown in early 2012 was caused by a short squeeze on TVIX. Its price rose well above its net asset value. The short squeeze occurred because the issuing bank reached its internal risk limits in respect of VIX futures. It hence stopped creating new TVIX units, removing the normal mechanism for keeping the ETF’s price near its net asset value. Holders of this strategy may well have had their TVIX shares called at the worst possible time – the minimum of the black curve – missing out on the subsequent recovery. The key problem with this strategy is, however, its tail risk. Gains from shorting a stock are limited to 100% of its value. Losses are unlimited. A large enough single-day increase in the value of VIX could see the strategy lose more than 100% of the notional investment. In particular, if a day sees the VIX short term futures index double or more, XIV – if it functions as designed – will go to zero. But TVIX can continue to rise, generating unhedged, potentially unlimited losses for the strategy. I suspect this is the main reason that the market allows this apparent inefficiency. Executing the strategy is equivalent to selling financial catastrophe insurance. Additional disclosure: I am sometimes long / short XIV, but do not execute this strategy.