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Protecting Yourself Against The Next Bond Liquidity Crunch

By DailyAlts Staff Anyone who lived through it knows that liquidity evaporated during the 2008-09 financial crisis. In response, the U.S. federal governments imposed a series of rules and regulations designed to make financial markets safer, but instead, they’ve contributed to even more illiquidity. What can investors do about it? That’s the question explored in Alliance Bernstein’s September 2015 white paper Playing with Fire: The Bond Liquidity Crunch and What To Do About It . Trading Turnover is Down The bond market has long been considered a safe haven during times of financial stress. Historically, well-capitalized banks have stood at the ready, willing to buy bonds – particularly investment-grade and government issues – when no other buyers were interested. But due to regulatory changes, banks are hamstrung from providing this service, and as a result, turnover in both investment-grade and high-yield bonds has plummeted since the financial crisis. Increased Correlation It’s not that demand is down: New bonds are being issued in record numbers, and investors are willing to buy. The problem is that during so-called “fire-sale” selloffs – when stocks, bonds, and commodities suffer sharp declines – bond-market liquidity is drying up, and thus sellers under duress must contend with wide bid/ask spreads and lower selling prices than they bargained for. And, as a result of the policies of the Federal Reserve and other central banks, these broad selloffs are becoming more and more common. The Impact of Central Banks In the wake of the financial crisis, when liquidity dried up, central banks began forcing down interest rates by buying government bonds and other assets, thereby expanding the money supply and flooding the markets with liquidity. Their bond buys pushed interest rates down and forced yield-minded investors into riskier assets. In addition to the U.S. Federal Reserve, the U.K.’s Bank of England, the EU’s European Central Bank, the Bank of Japan, and the People’s Bank of China have all massively expanded their balance sheets since 2009. Crowded Trades With lower rates on government bonds, stocks and other riskier assets become more attractive by comparison. While 0% interest rates may have made sense as an “emergency” policy measure, nearly ten years later, rates are still pegged near zero, but it appears things are likely to begin normalizing later this year, or in early 2016. It’s widely acknowledged that the Fed and other central banks have boosted bonds and other asset prices, so the reversal of their policies is likely to have the same effect – indeed, even the Fed’s threat of scaling back its “quantitative easing” bond-buying program in 2013 led to a “fire-sale” dubbed the Taper Tantrum. The risk in 2015 and into 2016 is that yield-starved investors have crowded into too many of the same trades, and that without banks standing on guard to buy during the next “fire-sale” selloff, there may be no takers (at reasonable prices), and thus a severe liquidity crunch. What to Do About It? So what can investors do about it? AllianceBernstein’s Head of Fixed Income Douglas Peebles and Head of Global Credit Ashish Shah, authors of the white paper, provide the following list: Diversify using a broad multi-sector strategy; Be a contrarian and avoid the crowd; Keep cash handy – and don’t neglect derivatives; Do your credit homework – and expand your investment horizon; and Consider select investments in private credit. Investors should vet asset managers as part of their “credit homework.” Peebles and Shah recommend asking managers questions to gauge their acumen, such as “To what do you attribute the decline in liquidity?” and “How has your process changed as liquidity has dried up?” In closing, the authors ask investors to remember: While the financial crisis did considerable damage to markets and investors, those who kept their cool – and who didn’t rely too much on liquidity – made a lot of money. For more information, download a pdf copy of the white paper .

Is XIV The Place To Be If Markets Stabilize And Volatility Declines?

Summary This large ETN is close to its year low and has lost 43% over the past year. As a play on a quiet fall market, is there money to be made when the VIX goes lower? We do an analysis of this heavily traded ETN and answer these questions and more. The VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) is a rather simplistic (on the surface) security to take advantage of a fall in volatility. According to the sponsor, VelocityShares, The ETNs are medium-term notes of Credit Suisse AG (“Credit Suisse”), the return on which is linked to the performance of either the S&P 500 VIX Short-Term Futures™ Index ER or the S&P 500 VIX Mid-Term Futures™ Index ER (each such index, an “Index” and collectively the “Indices”) The ETNs do have a maturity date of December 04, 2030 but for all intents of purposes the maturity only represents a future date for the instrument to be redeemed or perhaps extended. The ETNs pay no interest and there may or may not be a return of principal upon maturity. A majority of investors in this ETF use the vehicle to hedge against lower volatility. The turnover of only 2 days is indicative of this factor. We will analyze the basic structure and provide some of the key risk factors of this instrument that has seen a significant inflow of funds over the past month. A recent overall structure was quite simplistic: XIV Structure, as of September 10 Contract name Weight CBOE Short-term VIX Future Sept 2015 17.00% CBOE Short-term VIX Future Oct 2015 83.00% As noted, with only 17.00% of the futures contract focused on September, the balance now shifted to October one has an opportunity to participate in lower volatility. The underlying question is, is it that simple? Simply by waiting five days we find it is hardly that simple. Here is the revised structure five days later: XIV Structure, as of September 15 Contract Name Weight CBOE Short-term VIX Future Oct 2015 100% The October contract closed at 23.85 on September 10 and at 20.425 on September 15. All contracts from September have now been rolled over to the current month. As many analysts have stated simply the way VIX contracts are priced, investors will gain approximately 5.00% or more a month on the roll-over. This sounds fantastic and would appear to be a simple way to pick up a very nice return. There are multiple issues why this is not that easy or simple. Since this ETF functions as an inverse to the S&P 500 VIX and is really a short vehicle for the VIX in an ETN form the fund managers in Switzerland via their model and the prospectus must buy contracts that are about to expire and sell the next month. This would be defined as a contango strategy. As such, as noted, XIV may very well gain 5% or more per month simply by rolling future contracts (buying back the ones that are about to expire and sell the next month. The ETN must maintain a short position and bias at all times. The only problem is that not only will the fund lose money during market corrections but also when markets move sideways. These sideway moves occur during political gridlock, holiday periods, Federal Reserve indecision, economic malaise, and during electoral seasons, (in general) to name a few. One of the other problems is that the daily indicative value may be higher or lower than the closing price. As such, an investor can go to sleep believing they could not possibly lose money since the market is rallying overseas, while in fact they lose $.50 per share upon market opening. Fortunately, the share price over time has outperformed the indicative prices and the NAV. Presently the indicative price is $28.08 versus a closing price of $27.75 on September 15, according to Velocity Shares. The one month premium average to the NAV or indicative price has been .78%, reflecting the recent market correction. Many times, (including the presently) it trades at a discount. In terms of the market correction, here are some historical prices and percentage changes on XIV and since August 01 (using XIV closing prices and VIX settlement prices): Date XIV Price C hange Percentage Change VIX Futures Prices Sept/ Oct Change Percentage Change Aug 03, 2015 $48.76 NA NA 15.125 15.875 NA NA Sept 01, 2015 $22.01 -$26.75 -54.86% 29.725 25.825 14.60 9.95 96.52% 62.67% Sept 15, 2015 $27.75 -$21.01 $5.74 -43.08% 26.07% 22.575 20.425 7.45/-6.97 4.55/-5.40 49.25%/-23.46% 28.66%/-20.90% Note: The second numbers listed under change and percentage change are intermediate price changes, (since September 01). As noted above XIV has recouped 26.07% since September 01 and is climbing quickly as global markets settle down and rally, but is still down 43.08% since August 03. The October VIX has lost 20.90% since September 01, yet is still up 28.66% from August 01. Unfortunately, one cannot simply device a model or formula to determine the profit (or loss) potential when the VIX rallies or sells off versus the performance of the XIV. The best we can do is state a 1.24-1.50% correlation between the two. In other words when the VIX rallies an investor should loss approximately $1.25 for every dollar in XIV and when it falls gain approximately $1.50. This is not an exact mathematical formula but simply based upon our own correlation analysis. There are simply too many variables that influence the price action for this correlation to be valid over a significant period of time and further analysis is necessary. Investors should also be aware that the ETN has a net expense ratio of 1.35% versus a category average of 1.27%. In addition, the beta of the ETN is -.90 and the Alpha is -1.7 for the past three years. This is obviously almost a total negative correlation to the S&P 500, but not 100% or a perfect -1.00. A recent article in Barrons stated traders have shunned the ETN this month. Investors placed $345.00M in the ETN in late August, while have only put in $18.9M since September 03. The ETN presently has 1.48BLN market capitalization. The Barrons’ writer should have analyzed further why this is so. One way is to review the holdings of the ETN. Yes, many trader’s use this vehicle as a speculative tool. Predominately, there are large funds and institutions that have placed substantial funds in the ETN as a hedge vehicle for their pension and other large institutional investors. For example, Lazard Capital has a particular fondness or appetite for the vehicle, owning 72,250 shares or 1.76% in one of their Institutional Funds. In addition, Credit Suisse (NYSE: CS ) holds a 26.453% stake, UBS (NYSE: UBS ) 6.46%, and Citigroup (NYSE: C ) holds 3.42%, among other firms. Overall, institutions own approximately 74.04%, with mutual funds hold only .49%, according to Fidelity.com. As such, these institutions are not so much traders as they are hedgers. These investors are simply holding at this time and not adding to their position or selling. They have already placed their hedge for the next quarter. As such, they are using it as a vehicle for their overall holdings to take advantage of lower volatility and add “alpha,” without having to directly go to the futures market. In addition, there are many hedge funds that are using the vehicle to take advantage of a decline in volatility going forward. As a retail investor we feel that an investor may participate with the institutions but only with a portion of assets and on a strictly month to month basis. This is our primary reason in analyzed this ETF since August 01. Since the beginning of the year XIV is down 12.05%, but -44.61% since June 24 when it hit a price of $50.10. It is fruitless as a retail investor to use this ETN as a long term investment vehicle. A quarter to quarter investment or hedging tool to take advantage of calming markets and lower volatility is fine. Unfortunately, we would not recommend this vehicle as a long term, let alone cyclical type investment vehicle. The risks are simply too high as a buy and hold investment. Take advantage of the higher volatility, pick up a quick return of possibly 10% riding the wave of lower volatility, but don’t overstay the party. 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: Additional information and analysis is from velocitysharesetns.com, morningstar.com, fidelity.com, yahoofinance.com, tdameritrade.ca, cboe.com, and our own analysis.

Dollar Sensitivity: The New Style And Size Debate

By Jeremy Schwartz When making investment decisions, many are familiar with making allocation decisions between large and small caps or between growth and value stocks. These decisions to over- or under-weight different segments of the market are what drive relative returns, and depending on your allocation mix, the returns can be quite different. Recently, as a result of the divergence in central bank policies, investors have also had to take views on currency risk, with clear winners and losers. Increasingly, we have seen investors shift away from currency risk in the developed international markets-specifically Europe and Japan-and focus just on the equities through currency-hedged indexes. But what about the currency impact on domestic equities? Currency Factor in U.S. Equities Currency moves are not just important to foreign markets. In the U.S., we have also seen U.S. dollar strength impact stocks that are exposed to sales in foreign markets. It is widely known that a significant percentage of the revenues of U.S. companies in the S&P 500 Index comes from abroad. If the U.S. dollar continues to strengthen, this is likely to provide continued headwind for the companies with meaningful revenue from and business exposure in foreign markets. By contrast, if the U.S. dollar reverses, these firms should benefit. WisdomTree designed two new U.S. equity factor Indexes to help position investors according to their view of the U.S. dollar’s direction. WisdomTree Strong Dollar U.S. Equity Index (WTUSSD) – includes only firms that derive more than 80% of their revenues from the United States. These companies tend to be less impacted by a strong-dollar environment-they aren’t focused on selling their goods and services abroad, and their import costs decrease with the dollar’s rising purchasing power. The Index also tilts weight more heavily toward stocks whose returns have a higher correlation to the returns of the U.S. dollar. WisdomTree Weak Dollar U.S. Equity Index (WTUSWD) – includes only firms that derive at least 40% of their revenues from exports. These firms tend to be more impacted by a strong-dollar environment, as they are focused on selling their goods and services abroad. Similarly, during a weak-dollar period, we’d expect these firms to become more competitive in selling their goods abroad. The Index also tilts weight to stocks whose returns are more negatively correlated (or have a lower correlation) to the returns of the U.S. dollar. Below we compare the since-inception performance of the WisdomTree Dollar Indexes, as well as popular size and style indexes, to get a sense of divergence between factors. Index Performance (click to enlarge) For definitions of indexes in the chart, visit our glossary . Dollar Indexes Divergence: we find the 3.98% divergence between WTUSSD and WTUSWD interesting, especially considering the short-term performance period. Despite that and the fact that analyzing just performance is not a robust statistical analysis, it seems there have been clear winners and losers, with WTUSSD coming out ahead. It is also interesting that the discrepancy is larger than the 2.92% difference between the S&P 500 Growth and S&P 500 Value, leading us to believe that the WisdomTree Dollar Indexes are offering differentiated exposures. Performance Differences between Size Indexes: have been the smallest (at 0.23%) of the indexes shown above. The difference is interesting to us because we often hear that small caps should be impacted less by a strengthening dollar because their revenues are typically more domestically focused. We estimate the weighted average revenue from outside the U.S. at 19% and 38% for the S&P Small Cap 600 and the S&P 500 indexes, respectively. Again, the period is short and there could be other factors driving the returns, but it is something we will continue to monitor. Can the Separation Continue? One of the most important macroeconomic forces impacting the markets have been currency changes motivated by diverging monetary policies. If you believe the U.S. dollar will continue to strengthen over the coming years, as is WisdomTree’s baseline view, this could provide the backdrop for continued divergence among U.S. equities. The degree or speed of the divergence is hard to predict, but we think it will be important to continue monitoring the performance differences for this new factor and look to provide commentary around any continued divergence. Important Risks Related to this Article Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”