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Volatility Decays Without The Roll

“Roll Yield” is a frequently spoken about but lesser understood phenomenom. Volatility futures decay without the roll. Continue to short volatility for excellent long-run gains. Roll decay is a term that is commonly thrown around when discussing futures. It is an easily observable phenomenon in commodities markets that results from a positively sloping forward curve. When an electronically-traded-product “rolls” contracts along such a curve, it sells near-term futures and uses the proceeds to buy further-out futures. In rolling, the net value of the fund has not changed. Maybe 12 near-term contracts valued at $10 each were sold for 10 further-out $12 contracts. The gross value is $120 immediately before the transaction and $120 immediately after the transaction. There is no decay in asset value. The decay happens afterwards…sometimes. In the example above, both contracts were priced above the spot rate, and the further-out contract was priced above the near-term. If the underlying asset is a random walk, then on average (long-term average), the moving average of the spot will be equal to the current spot. In other words, the expected return on carry is 0. So both futures will need to drift down, and the further-out future will need to drift down more. In the real world, most assets are not a random walk. They tend to drift themselves. If they are positively correlated with the market, they tend to drift upwards; and vice versa. In commodities and equities markets, this drift is fairly deterministic in the long-run and becomes implicit in the term structure. Therefore the “roll” decay is, in fact, a result of rolling less-overpriced contracts into more-overpriced contracts. The VIX is very different. It’s not a random walk. It’s a random spring. It makes a lot of noise but its long-run moving average is very predictable. When the VIX spot is $12 and the first month future is $14, the empirically derived mathematical expectation of the first future isn’t to converge to $12. Instead it is to converge to something like $13, as the spot springs from $12 back toward its center and hits $13 along the way. Likewise when the VIX spot is $30 and the first month future is $26, a long position on the first month future still decays (on average) because the spot drops down to something like $25 on average. Please see this article for elaboration: The take away is that the slope of the volatility forward curve is of little to no consequence. ETN’s like TVIX, VXX, and VXZ will continue to decay so long as they are tied to VIX futures that are themselves individually overpriced (in comparison to their mathematical/statistical expectations.) For something like the VXX, the “roll” decay occurs because it is in constant possession of two futures contracts (M1 and M2), that are in an almost perpetual state of being over-priced. The allocations are irrelevant. If VXX stopped rolling contracts, any static mix of M1 and M2 would show similar performance on average. Volatility futures decay standing still. So unless you have a crystal ball or an uncanny ability to predict the future, betting against volatility futures continues to be highly advisable. There will be plenty of noise short-term, but long-term bets will reap in the green. And plea se see the following article if you would like to drown-out some of the noise: 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. Additional disclosure: I am short volatility futures.

Decoding The Myths Of Managed Futures 2015

This paper examines seven very popular myths and misconceptions held by both retail and institutional investors regarding managed futures. These myths have persisted for several years. Knowing if the myths are true or false is critical for an investor’s understanding and appreciation of managed futures. From presenting at more panel events, instructing workshops on alternative investments and teaching my managed futures/ global macro course at DePaul University in the last several years, I found it was time to update the original paper written in 2011 with additional myths added to the list. The demand for alternative investments continues to grow as investors are seeking more ways to decrease their correlation risk and tail risk of their portfolio. After the dot com bubble and the recession in the early 2000s more investors realized the need for wider diversification beyond stocks and bonds. More recently since the financial crisis the demand to reduce correlation risk and tail risk continues to grow. Managed futures (AKA Commodity Trading Advisors), a subset of alternative investments and sometimes categorized under global macro hedge funds continues to grow in popularity. However, many old myths still persist about the investment product, the managers and the due diligence of the managers. As of the end of 2014, assets under management have grown by 736% since 2000 and by 53% since 2008, according to BarclayHedge . 2011, 2012 and 2013 were challenging years for the returns of managed futures and the product found itself out of favor. But no one has a crystal ball to know when markets change and the 2nd half 2014 gave CTAs a positive year while equities were experiencing greater volatility in the latter part of 2014. As of March 2015, CTAs continue to profit. A fair amount of the recent growth in managed futures has been driven by the increasing interest for both commodity related investments as well greater non-correlation of portfolio allocations. Below are some of the myths and misconceptions of managed futures: Mysterious “black box” trading systems Managed futures are a hedge or insurance against equities Only commodities are traded Managed futures are risky and volatile All Commodity Trading Advisors are the same CTA indices contain survivorship bias All CTAs are large firms The discussions below are tendencies of the managed futures industry. Results may vary with individual managers. 1: Mysterious “Black Box” Trading Systems Over the years I’ve often heard investors or allocators state “we don’t understand or can’t get comfortable with the systematic trading models” and “they are black boxes, so we stay away from them.” Systematic trading models are quantitative computerized trading models. In earlier years, many CTAs were cautious of fully explaining their models due to replication risk. However, in more recent years there is a trend towards CTAs explaining their models. But the transparency by the CTA is not enough. It also involves the investors and allocators to do their research in understanding the concepts and terminology of the asset as they do their due diligence, just as they would for any other investment. 2: Hedge or Insurance against Equities Many believe that managed futures are a hedge or insurance against equities. This is not true. CTAs tend to be non-correlated to equities. This means their returns are independent of equity returns. The independent returns are primarily due to CTAs trading various commodity and financial markets and they can be long, short, neutral or spreading in those markets. In the last 20 years managed futures have shown moments of having a positive correlation to equities when equities rally and in other moments a negative correlation to equities when equities decline. Over time the correlation cycles between positive and negative. But they tend to show positive performance when there are “shocks” to the various markets or the economy such as in the early 2000’s and in 2008. A CTA does not care about the direction of the market they trade, but only that there is enough of a move to create a profit. 3: Only Commodities Are Traded Because the managers who trade futures are called Commodity Trading Advisors, there is a myth that only commodities are traded. Some CTAs do trade only commodities or only trade one market or sector such as corn or the grain sector. But many trade only financial futures such as stock index futures, bond futures or currency futures or forwards. Diversified CTAs may trade both financial and commodity futures. 4: Managed Futures Are Volatile Some CTAs can be volatile, just as any other investment has the potential to be volatile or risky. However, if you look at volatility in terms of the Sharpe ratio and or standard deviation, then you are also assuming the return distributions are a normal (bell-curve) distribution. CTAs may have low Sharpe ratios, high standard deviations, thus one would believe they are very risky and volatile. However, the low Sharpe ratio and high standard deviation are often derived from positive skewness of the return distribution due to risk management policies. One must understand the source of volatility returns. Volatility is similar to cholesterol; there is good volatility and bad volatility. Good volatility is derived from positive returns and the bad volatility derived from negative returns. The Sortino ratio and S-ratio are probably more informative in understanding risk-adjusted returns for a non-normal distribution than the Sharpe ratio or standard deviation. It may sound counter-intuitive, but adding an investment with a high standard deviation may actually reduce the portfolio’s volatility due to the positive skewness. In doing so to analyze the investment not as a standalone investment, but how does it compliment the portfolio. 5: Managed Futures Funds Are All the Same Some investors will ask “why do I need to invest in more than one CTA? Aren’t all CTAs the same?” The answer to that is NO! This topic can be detailed in a separate discussion, but they are not all the same for some basic reasons: 1) Some CTAs may trade different markets or varying number of markets. 2) Their time horizons or average trade duration may vary. 3) How they get into or out of positions may vary. 4) How they manage risk, one of the most important components of the trading system may vary among the CTAs. As I tell my students at DePaul University, the risk management of the positions may make or break a manager. 6: CTA Indices Contain Survivorship Bias Some investors will refrain from investing in managed futures because the indices include survivorship bias. They are correct, the indices usually do contain survivorship bias. This bias relates to managers being taken out of the index because they no longer meet a certain requirement to be in the index or they are no longer in business. Managers may also be taken out of an index because they stop reporting to the databases. One common reason for a manager to stop reporting their returns is if they reach a certain asset size and are no longer seeking to raise funds. What is often missed is that most investment indices do include survivorship bias. For example, General Electric was one of the original components in the Dow Jones index. They are now the only remaining original constituent. Over the decades DJ and S&P have added and removed companies from their respective indices. If survivorship bias is a reason for an investor to avoid investing in managed futures then why isn’t the same logic applied to equities? 7: All CTAs are Large Firms Often new investors in the managed futures space may know of a few large CTAs and think all CTAs are large firms with hundreds of millions if not billions of dollars under management, millions spent on technology, a large research staff and a deep infrastructure. However, it is more common for a CTA to be a small business. They will often have from 2 to 10 employees. Using easily accessible technology and many back office functions outsourced to third party firms. This should not take away from investing in the smaller “emerging” managers, but to understand and appreciate the makeup of the industry. In summary, we have discussed some of the myths or misconceptions that have persisted over the years regarding managed futures. As the industry has become more transparent of their research and demand for non-correlated assets have increased, there is a need for investors to do their research, understand the product, as they would with any other asset class they explore to invest in and understand the profile of the managers they investigate. 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. I have no business relationship with any company whose stock is mentioned in this article.

F.U.D. And Dividend Shock Absorbers

As the existential question remains open on whether Greece will remain a functioning entity within the eurozone, investor anxiety and manic behavior continues to be the norm. Rampant fear seems very counterintuitive for a stock market that has more than tripled in value from early 2009 with the S&P 500 index only sitting -3% below all-time record highs. Common sense would dictate that euphoric investor appetites have contributed to years of new record highs in the U.S. stock market, but that isn’t the case now. Rather, the enormous appreciation experienced in recent years can be better explained by the trillions of dollars directed towards buoyant share buybacks and mergers. With a bull market still briskly running into its sixth year, where can we find the evidence for all this anxiety? Well, if you don’t believe all the nail biting concerns you hear from friends, family members, and co-workers about a Grexit (Greek exit from the euro), Chinese stock market bubble, Puerto Rico collapse, and/or impending Fed rate hike, then here are a few confirming data points. For starters, let’s take a look at the record $8 trillion of cash being stuffed under the mattress at near 0% rates in savings deposits ( see chart below ). The unbelievable 15% annual growth rate in cash hoarding since the turn of the century is even scarier once you consider the massive value destruction from the eroding impact of inflation and the colossal opportunity costs lost from gains and yields in alternative investments . (click to enlarge) Next, you can witness the irrational risk averse behavior of investors piling into low ( and negative ) yielding bonds. Case in point are the 10-year yields in developing countries like Germany, Japan, and the U.S. ( see chart below ). (click to enlarge) The 25-year downward trend in rates is a very scary development for yield-hungry investors. The picture doesn’t look much prettier once you realize the compensation for holding a 30-year bond (currently +3.2%) is only +0.8% more than holding the same Treasury bond for 10 years (now +2.4%). Yes, it is true that sluggish global growth and tame inflation is keeping a lid on interest rates, but these trends highlight once again that F.U.D. (fear, uncertainty, and doubt) has more to do with the perceived flight to safety and high bond prices (low bond yields). In addition, the -$57 billion in outflows out of U.S. equity funds this year is further evidence that F.U.D. is out in full force. As I’ve noted on repeated occasions, when the tide turns on a sustained multi-year basis and investors dive head first into stocks, this will be proof that the bull market is long in the tooth and conservatism should be the default posture. There are always plenty of scary headlines that tempt investors to bail out of their investments. Today those alarming headlines span from Greece and China to Puerto Rico and the Federal Reserve. When the winds of fear, uncertainty, and doubt are fiercely swirling, it’s important to remember that any investment strategy should be constructed in a diversified manner that meshes with your time horizon and risk tolerance. Consistent with maintaining a diversified portfolio, owning reliable dividend paying stocks is an important component of investment strategy, especially during volatile periods like we are experiencing currently. Sure, I still love to own high octane, non-dividend growth stocks in my personal and client portfolios, but owning stocks with a healthy stream of dividends serve as shock absorbers in bumpy markets with periodic surprise potholes. As I’ve note before, bond issuers don’t call up investors and raise periodic coupon payments out of the kindness of their hearts, but stock issuers can and do raise dividends (see chart below). Most people don’t realize it, but over the last 100 years, dividends have accounted for approximately 40% of stocks’ total return as measured by the S&P 500. (click to enlarge) Source: BuyUpside.com Markets will continue to move up and down on the news du jour, but dividends overall remain fairly steady. In the worst financial crisis in a generation, dividends dipped temporarily, but as I explain in a previous article ( The Gift that Keeps on Giving ), dividends have been on a fairly consistent 6% growth trajectory over the last two decades. With corporate dividend payout ratios well below long term historical averages of 50%, companies still have plenty of room to maintain (and grow) dividends – even if the economy and corporate profits slow. Don’t succumb to all the F.U.D., and if you feel yourself beginning to fall into that trap, re-evaluate your portfolio to make sure your diversified portfolio has some shock absorbers in the form of dividend paying stocks. That way your portfolio can handle those unexpected financial potholes that repeatedly pop up. DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and SPY, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page .