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Inside HACK: The Sought-After Cyber Security ETF

The cyber security industry has gained immense popularity in recent years and is the fastest-growing corner of the broad technology space. This is because cyber-attacks on enterprises and government agencies are widespread with growing Internet usage, raising the need for more stringent cyber security from hackers. Hacking has become more sophisticated, dangerous and harder for companies (and even governments) to stop. According to the report from the Global State of Information Security Survey 2015, cyber attacks across the globe have risen about 66% over the past five years and 48% from 2013. Some of the well-known companies in the recent spate of data breaches include Target (NYSE: TGT ), eBay (NASDAQ: EBAY ), Home Depot (NYSE: HD ), AT&T (NYSE: T ) and JPMorgan Chase (NYSE: JPM ). The situation will likely to worsen in 2015, as hackers will continue to adopt advanced techniques and strategies to infiltrate networks hiding their tracks. Solid Long-Term Prospects As per McAfee, cyber-warfare and espionage attacks are expected to increase in frequency. Attacks on Internet of Things (IoT) devices will rise rapidly due to whopping growth in the number of connected objects, poor security and the high value of data on IoT devices. And new mobile technologies will allow more mobile attacks. Growing awareness for the protection against these cyber threats will continue to propel demand for spending on information security. According to Gartner, global security spending will increase to $76.9 billion in 2015 from the expected $71.1 billion in 2014. Most of the growth will likely come from the rapid adoption of mobile, cloud, social and information technologies. Another data from ABI research showed that global cyber-security spending would reach $109 billion by 2020. Investors could easily tap the cyber-security spending boom and rising demand in a basket form. Investors should note that there is currently one ETF – PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) – which offers exposure to those companies that ensure the safety of computer hardware, software, networks and fight against any sort of cyber malpractices. The fund provides a good opportunity for investors to play the niche area of cyber security. This is especially true as it has been getting the first-mover advantage and has accumulated $157 million in AUM in just two months of debut while surging 3.6% in the same period. Average daily volume is solid as it exchanges nearly 227,000 shares in hand. Given this, it might be worth it to shed some light on this ETF and its holdings for those who are unfamiliar with the product, but are thinking about jumping in on the space. Below, we highlight some of the key details regarding HACK, which made it one of the fastest-growing and most successful ETFs of last year. HACK in Focus The ETF tracks the ISE Cyber Security Index, holding 30 securities in its basket. It is well spread out across components as each security holds no more than 5.01% of total assets. Ahnlab, Infoblox (NYSE: BLOX ), and Fireeye (NASDAQ: FEYE ) occupy the top three positions in the basket. From an industrial look, software and programming accounts for nearly two-thirds of the portfolio while communication equipment and Internet mobile applications round off the top three with a double-digit allocation each. In terms of country exposure, U.S. firms take the top spot at 72%, followed by Israel (12%), the Netherlands (5%), South Korea (5%), Japan (4%), Finland (2%) and Canada (1%).

How Does VXX’s Daily Roll Work?

All volatility Exchange Traded Products (ETPs) use indexes that track a mix of two or more months of the CBOE’s VIX Futures. Calculating this mix is not trivial and has resulted in a lot of bleary eyes – including my own. My intent with this post is to help you understand, and if you desire, accurately compute the key indexes used in the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ) and other short-term volatility funds using Excel or similar tools. Why do we need a roll anyway? If we could directly buy the CBOE’s VIX index none of this would be necessary. Unfortunately, no one has figured out a cost effective approach so we are forced to use the next best thing – VIX Futures. Like options, VIX futures have fixed expiration dates so volatility indexes need a process of rotating their inventory of futures in order to have consistent exposure to volatility. This rotation process is evident in the open interest chart below – the next to expire futures being closed out and the next month of futures being opened. Indexes and Funds are different things Before we dive into the details of how this rotation is dealt with, I’d like to address one source of confusion. ETPs are not obligated to follow the approach detailed in the indexes. They are allowed to use other approaches (e.g., over-the-counter swaps) in their efforts to track their indexes. When ETPs are working properly, their prices closely track the index they specify in their prospectus minus their fees that are deducted on a daily basis. Because indexes are theoretical constructs they can ignore some practical realities. For example, they implicitly assume fractional VIX futures contracts exist and that the next day’s position can be put in place at market close – even though calculating that position requires market close information. I’m sure these issues cause headaches for the fund managers, but to their credit the funds usually closely track their index. The Index Calculation The details for the index (ticker SPVXSTR ) that VXX tracks are detailed in VXX’s prospectus , pages PS-21 through PS-22. The math is general enough that it covers both the short term index that VXX uses and the midterm index VXZ uses – which adds to its complexity. The equations use Sigma (?) notation, which probably makes it challenging for people that haven’t studied college level mathematics. I will present the math below using high school level algebra. Except for interest calculations all references to days are trading days, excluding market holidays and weekends. The volatility indexes used by short-term volatility ETPs ( list of all USA volatility ETPs ) utilize the same roll algorithm – at the end of each trading day they systematically reduce the portion of the overall portfolio allocated to the nearest to expiration contracts (which I call M1) and increase the number of the next month’s contracts (M2). The mix percentages are set by the number of trading days remaining on the M1 contract and the total number of days it’s the next to expire contract (varies between 16 and 25 days). So if there are 10 days before expiration of the M1 contract out of a total of 21 the mix ratio for M1 will be 10/21 and 11/21 for M2. At close on the Tuesday before the Wednesday morning M1 expiration there’s no mix because 100% of the portfolio is invested in M2 contracts. It’s important to understand that the mix is managed as a portfolio dollar value, not by the number of futures contracts. For example, assume the value at market close of a VIX futures portfolio was $2,020,000, and it was composed of 75 M1 contracts valued at 12 and 80 M2 contracts at 14 (VIX futures contracts have a notional value of $1K times the trading value). To shift that portfolio to a 9/21 mix for M1 and 12/21 for M2 you should take the entire value of the portfolio and multiply it by 9/21 to get the new dollar allocation for M1, $865,714 (72.14 contracts) and 12/21 times the entire portfolio value to get the dollar allocation for M2, $1,154,286 (82.45 contracts). Value weighting gives the index a consistent volatility horizon (e.g., 30 calendar days) – otherwise higher valued futures would be disproportionately weighted. The next section is for people that want to compute the index themselves. Yes, there are people that do that. If you are interested in the supposed “buy high, sell low” theory of roll loss you should check out the “Contango Losses” topic at the bottom of this post. The Variables Lower case “t” stands for the current trading day, “t-1” stands for the previous trading day. The index level for today (IndexTR t ) is equal to yesterday’s index (IndexTR t-1 ) multiplied by a one plus a complex ratio plus the Treasury Bill Return TBR t. The index creators arbitrarily set the starting value of the index to be 100,000 on December 20th, 2005. The number of trading days remaining on the M1 contract is designated by “dr” and the total number of trading days on the M1 contract is “dt.” M1 and M2 are the daily mark-to market settlement values, not the close values of the VIX futures. The CBOE provides historical data on VIX futures back to 2004 here . The Equations When dr is not equal to dt: When dr = dt (the day the previous M1 expires): Yes, this equation could be simplified, but then it wouldn’t fit as nicely into the equation below which uses a little logic to combine both cases: The equation assumes that the entire index value is invested in treasury bills. Contango Losses An interesting special case occurs when you assume that the M1 and M2 prices are completely stable and in a contango term structure for multiple days-for example, M1 at 17 and M2 at 18. In that situation the equation simplifies to: This special case illustrates that there is no erosion of the index value just because it’s selling lower price futures and buying higher priced futures-in fact it goes up because of T-bill interest. It’s the equivalent of exchanging two nickels for a dime-no money is lost. For more on this see: The Cost of Contango-It’s Not the Daily Roll . Disclosure: None

Switzerland’s Monetary Policy Change – GLD Rallies

The Swiss National Bank’s decision to end its policy to peg the Swiss franc to the euro stirred up the financial markets. The decision seems to have also pulled up the price of GLD. How SNB’s decisions relates to the recent rally of GLD. The big news from the Swiss National Bank to stop pegging its currency to the euro has shocked the foreign exchange markets. Some analysts have also linked this move to the recent recovery of gold, including the SPDR Gold Trust ETF (NYSEARCA: GLD ). This relation, however, isn’t straightforward – let’s examine the recent rally of GLD . After over three years, the SNB announced an end to its policy to peg the currency at a minimum exchange rate of 1.20 euro to the Swiss franc. The ongoing devaluation of the euro has, according to the bank, triggered it to make this move. As Thomas Jordan, chairman of the SNB, stated : “Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.” This decision has stirred up the financial markets – mainly devaluing the euro against leading currencies, including the U.S. dollar. Normally, an appreciation of the U.S. dollar would tend to coincide with a decline in the price of GLD. But the price of GLD kept going up. The SNB’s recent move actually raises the uncertainty in the financial markets, which plays in favor of gold investments such as GLD. Paul Krugman suggested that the implication of the recent regime change in Switzerland is that the markets will become more skeptical about other central banks, speculating whether these banks will follow through on their dovish policies. I think this is a bit of stretch, but some traders will make this connection – albeit one central bank’s policy change won’t necessarily impact the reliability of other banks. The latest news from SNB suggests the ECB’s next policy change could surprise the markets with a bigger than currently expected QE program. When it comes to GLD, however, the main issues relate to the changes in the U.S. dollar, the uncertainty in the markets and long-term treasuries yields. In the past week, the U.S. dollar devalued against the Swiss franc, which is now likely to keep recovering. U.S. long-term treasuries’ yields kept falling down, which tend to have a negative relation with the price of GLD. An economic slowdown does play in favor of GLD, because it tends to cut down U.S. treasuries’ yields. Moreover, the World Bank recently released its updated economic outlook for the next few years. The bank projects the global economy will grow by 3%, and not 3.4% as it previously estimated. It also revised down its outlook for China, EU and Japan. Albeit the U.S. GDP is expected to actually grow faster than previously estimated, the fear factor of global economic slowdown is keeping GLD up at least in the short term. This is another indication why the demand for gold on paper leads the way for physical demand for gold; if it were the other way around, an expected lower growth rate in China’s economy – the leading importer of gold – would have resulted in a drop in the price of gold. In any case, it seems that the physical demand for gold in the short term hasn’t picked up: The Gold Forward Offered Rate, or GOFO, has risen in recent weeks, after they were negative during part of December of 2014 (and several other times during last year). A rise in GOFO rates is another indication for a fall in the short-term physical demand for gold. The next big news item will be the upcoming ECB monetary policy meeting next week. This time, all eyes will be towards ECB president Draghi to see if he states the amount of the ECB’s QE program. Current market expectations are around 500-700 billion euros, albeit some have also suggested this figure could, in theory, even reach 2 trillion euros. So any number higher than this could drive further down the euro, which could push more investors towards precious metals, including GLD. Again, the appreciation of the U.S. dollar isn’t helping GLD, but a fear of ECB pumping cash into EU’s banks to buy sovereign debt could drive higher the demand for the yellow metal. The Swiss National Bank’s move shook up the foreign exchange market and apparently also, in the process, pulled up GLD. The next ECB monetary policy meeting could also be the next big event to stir up the foreign exchange markets and GLD – in times of uncertainty, GLD strives. (For more please see: ” On Demand for Gold and GOFO rates “)