Tag Archives: premium-authors

The One Factor To Explain Them All

Yesterday’s post on hedge funds got me thinking again about how vague “risk factors” are. CAPM uses a one factor model showing that risk explained why certain assets performed better than others.¹ Basically, take more risk and you’ll generate a better return. That didn’t exactly explain things fully though. In fact, higher risk often correlates with worse returns.² Over the course of the last 25 years the idea of “factor investing” has really boomed. And investment companies loved this because they could market specific stylized facts that explained why the markets do certain things and why you should pay them high fees so they can take advantage of those things for you. Heck, even hardcore passive investors, who are notorious fee avoiders, will trip over themselves buying higher fee funds trying to guess the best factors to own at certain times. As a result, we got the small cap factor and the value factor and the momentum factor and all sorts of other factors. I think we’re up to 1,000+ factors now. There are so many I could just start making them up. And I will. Right now. For instance, companies whose founders are dog owners might outperform companies whose founders are cat owners. This is a perfectly logical assumption because dogs are better than cats so company founders who own dogs must be smarter than company founders who own cats. So, we now have the dog vs cat factor. If I tweak some data and find it’s statistically meaningful over long periods of time then I might even start a high fee fund to sell you. No cat owners allowed, obviously. Okay, okay. I am being stupid. I know. But you see my point, right? A lot of these “factors” could be nothing more than slick data mining by someone who found a pattern that doesn’t really exist. We want to understand and be able to predict things so badly that we often find stylized facts where they don’t even exist. But maybe we just can’t know. That doesn’t mean it’s not worth trying to find out or to try guessing about future outcomes. But we should start from one general factor: The We-Know-A-Lot-Less-Than-We-Think-We-Know Factor This doesn’t require some law of the financial markets that says anything has to outperform anything else over the long-term. Yes, we know that stocks will generally beat bonds because they’re a contract that gives the equity owner greater claim to profits than the bonds, but that doesn’t mean stocks have to outperform bonds or even that they’re more risky (whatever “risk” means in the context of this discussion to begin with, but that’s a whole other matter). The point is, you don’t necessarily earn a “risk premia” in stocks. You earn a contractual premia assuming the firm earns enough profit to pay it out (good luck predicting which firms will generate the highest profits in the future) and a bunch of apes with keyboards try to guess what the future value of those profits will be. Importantly, no one needs the efficient market hypothesis to understand why markets are really hard to beat. You just need the basic arithmetic of global asset allocation to understand that . This whole monetary system is something humans created from thin air. And we have, at best, an imprecise understanding of what financial assets are really worth at certain times and so the best we can do is try to understand the world for what it is, slap together some sound assumptions about the future, reduce our frictions, manage the known risks as best as possible and hope it doesn’t all fall apart at some point. Is it really much more complex than that? ¹ – Here’s the Three Factor Model. Here’s the Five Factor Model. Here’s a 100+ Factor model paper. Here’s a real model. 2 – See this paper titled ” High idiosyncratic volatility and low returns: International and further U.S. evidence “.

Time To Short Volatility Again

VXX has spiked in recent days on China fears. But I think the conditions for a short of VXX have been met. Contango has disappeared and that has been a reliable signal in the past. I’ve written several times in 2015 about volatility and specifically, shorting the popular short term VIX ETF proxy VXX (NYSEARCA: VXX ) as I’ve taken the occasion of various spikes to bet on normalization. Last time I wrote about such a trade it was during the July meltdown stemming from the now-distant Greek crisis and that trade returned very nice profits, as you can see below. Well, here we are again as the VXX is spiking once more on China’s woes or any other global event investors can think of. (click to enlarge) My basic premise for entering a short VXX trade is pretty simple; wait for a spike in VXX, assess the reasonableness for a sustained higher VIX level and if there is none, short VXX. It really isn’t more complicated than that. VXX is a great vehicle to short because of its famous contango. It costs money (most of the time) to hold VXX due to contango so the opposite of that is that shorting it has a natural tailwind. This is the second cue for me in knowing when to short VXX and when to wait for a better entry point. But first, let’s assess why the VIX is spiking. Seems to me market participants are up in arms about China’s most recent meltdown and while that’s fine, just like the Greek crisis, I believe fears are overblown here. S&P earnings are also suffering somewhat and the market is losing leadership in a lot of ways so for me, that is a much bigger problem than China’s latest bubble popping. I know there are many people that would disagree with me but I just don’t get it on China. Therefore, the first condition of my short signal has been met; the reason for the spike seems improper and in particular, the magnitude with which VXX has spiked. We’re up double digits in two days on the VXX and for what? The second signal I mentioned is when VXX is no longer in contango, that has historically been a great time to short it. I like to use VIX Central to chart the VIX curve and determine the level of contango because it makes it easy for even novice VIX watchers to understand what is happening. I’ve pulled two charts from VIX Central below to illustrate my point. This first chart is a straight look at the VIX curve. Since the VXX deals with short term VIX contracts, we’re really only interested in the first two months. As you can see, as of yesterday’s close September and October were at exactly the same level and even November and December were only pennies higher than the front month. That means contango has disappeared and when that has happened in the past, it was a great time to short VXX. This chart shows the level of contango between the first and second month VIX contracts for the past several years and as you can see, flat contango and backwardation are rare. But when either of those conditions are met, we are usually due for a sell-off in front month VIX. That means that when we reach the level of contango we are at right now (zero, the red line on the chart), while we may move a little higher, history suggests the odds are heavily in favor of shorting VXX right now. So here’s the setup; the SPY just hit a six month low yesterday and after the beating the market has taken in the last couple of days, I think today will be a flat to lower day. That means VXX will probably be higher on Friday and that is where I will make my short. I will use the recent spike in VXX to short it as I think we are nearing the top of this particular spike. Now, I’ll make my standard VXX trade disclaimer because I don’t want anyone to get the wrong impression. Trading VXX is very risky and extremely volatile and thus, you must understand that the potential reward is high but so is potential risk. Please understand what you’re doing before taking a long or short position in VXX because it moves around a lot and can make or lose you a lot of money in a very short amount of time. I’ve been on both sides of VXX trades and I can tell you it can wipe out a lot of value quickly. The odds are in favor of a VXX short right now and I think today is the perfect opportunity to take a short position in VXX given that the spike in volatility seems overblown. I also think the market is near a base and will rally from here so that is also a favorable setup for shorting VXX. This position is not without risk but given the setup we have now, VXX shorts are heavily favored here. Good luck out there. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in VXX over 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.

Response To: Structured Note Read The Fine Print

Response to a biased article by AllianceBernstein on Structured Notes. Structured Notes may be helpful in introducing, reducing or modifying risk. The referenced Structured Note is not given credit in the referenced article for the downside protection it provides. Furthermore, to compare to a balanced portfolio which wins in all markets is unrealistic. I recently came upon a Seeking Alpha article by Alliance Bernstein titled Structured Notes: Read the Fine Print . The article expressed a fairly negative and, in my opinion, inaccurate view of structured investing based on an analysis of one structured note in particular. As an experienced structurer and trader prior to founding Exceed Investments, I’d like to help set the record straight. The article analyzes a 5-year 28% buffered note on the S&P 500 as an example. While they do not share a link to the terms, the note is similar to, if not exactly the same, as this note . First, let’s briefly consider what a structured note is and discuss its purpose. Structured notes are an example of what I call “defined outcome” investments, which are options-based strategies that allow investors to shape a risk/ reward exposure to fit their personal objectives. In these strategies, market participation levels are preset. Therefore, the targeted downside participation is known in advance, as is the upside potential. A defined outcome investment can be built to introduce risk, reduce risk, or modify it – in this case, the 28% buffered note offers S&P exposure with a material level of downside protection, which I will refer to as downside “insurance” in this article. Performance at maturity, assuming no default of the issuer, looks like this (X axis is Adjusted S&P 500 return; Y axis is the Note return): An investor may be interested in this product if they are risk-averse but still want to participate in equity markets (e.g., an executive who is retiring in 5 years from now and can’t take a big hit over the next 5 years). The “insurance policy” of this note will cover up to 28% of downside “damage” 5 years from now – e.g., market down 28%, investor loses 0, market down 40%, investor loses 12%. As in all insurance policies, a premium needs to be paid – in this case, the investor loses all dividends of the S&P 500. Over 5 years, those lost dividends amount to about 12% in a reasonable model scenario (2% annual dividend rate, assumed reinvestment at a compounded 8%). Is 28% of potential downside insurance worth giving up 12% of dividend upside, while still participating in the price appreciation of the S&P 500? There’s no right answer to that question as it depends on an individual’s needs and perspectives. As mentioned, I found a number of inaccuracies and misrepresentations (e.g., expense levels, liquidity) in the article but will focus on the main items which I found to be flawed. To summarize: The article directly compares the expected performance of the S&P 500 with the Note, without fairly pointing out the insurance benefit provided by the Note The article then compares the performance of a balanced portfolio with the Note, which I find two issues with – Why compare a product vs. a balanced portfolio? It’s an unfair comparison – no sane investor would invest all their funds in a single note The balanced portfolio described is somehow expected to gain during equity declines as well as fairly closely match bull returns, which is just impossible Greater detail follows: “Our analysis suggests that this structured note has an 80% chance of underperforming the S&P 500 over the next five years…” On one hand, while I can’t attest to the accuracy of their model, it seems reasonable. The note will underperform the S&P if the S&P finishes > -12% after 5 years. That’s because the cost of the insurance purchased, (i.e., 12% of lost dividends), will be greater than the insurance “payout” if the market isn’t down by more than 12%. Given historical performance, odds are the S&P does better than a cumulative -12% over the next 5 years. On the other hand, this isn’t a fair statement. If an investor buys any type of insurance, (e.g., earthquake insurance, fire insurance, theft insurance) and there is no major catastrophe in the next 5 years, which is usually the case, the investor will lag the performance of people who didn’t buy insurance. The same is true of buying 28% worth of portfolio insurance – if the market isn’t down by at least your premium spent, you will lag. That obviously doesn’t mean ipso facto that no one should buy insurance. “Projecting thousands of plausible outcomes across all types of market environments, we found that the median outcome for the structured note is more than 6% below what we’d expect from a fully diversified balanced portfolio, as the next Display ” For starters, no reasonable investor would take all their assets and purchase this single structured note vs. choosing a balanced portfolio. A more reasonable approach to this comparison may be to replace a relevant component of the balanced portfolio, for instance large cap value, with the structured note and then stress test outcomes between the two varying portfolios. Now let’s talk about the finding that a balanced portfolio over 5 years results in a median 4.5% return when the stock market finishes down, and a median 38% return when the market finishes up (which is apparently just about equal to the S&P price return). While I am sure their model is well designed, this simply doesn’t pass the smell test. How did individuals with balanced portfolios do in 2008? Hint: not very well. I am not aware of any product or portfolio design that had positive returns in 2008 and then proceeded to equal the price return of the S&P 500 over the following five years. If someone else is, please share it with me so I can invest. In conclusion, while I acknowledge that Structured Notes have issues (I cover them in detail at the end of this white paper ), which is what drove me to found Exceed Investments in the first place, this article does not treat them fairly. Ultimately, the referenced note provides a very defined risk / reward exposure to the S&P 500, providing a level of downside protection that may be deemed appropriate and/or may resonate for a subset of investors. 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.