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2 Words Of Caution For The VelocityShares Daily Inverse VIX Short-Term ETN

There are some articles on SA which have recommended purchasing the XIV, based on its pronounced outperformance of the market. However, investors who are tempted to initiate a position in this ETF should be very well aware of its extremely high risk. XIV can go to zero on a single day. It lost 71% in the summer of 2011, while the market lost 16%. There are some articles on SA which have recommended purchasing the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). These articles emphasize the exceptional returns of this ETF since its introduction 5 years ago, as well as its pronounced outperformance of the S&P (288% vs. 78%). However, investors who are tempted to initiate a position in this ETF should be very well aware of its extremely high risk. Therefore, I consider it irresponsible of those who recommend it without mentioning its risk. First of all, XIV aims to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. Therefore, XIV exhibits great performance when the market rises and volatility is low. Even better, when the market is in a calm status, the VIX futures exhibit a marked contango structure (the prompt futures are much cheaper than the distant futures) and hence XIV gains about 5% per month only from rolling its futures (buying back the ones that are about to expire and selling those of the next month). This is the strength of XIV; even if volatility is flat, XIV gains about 5% per month thanks to the contango structure, which is an exceptional return. Unfortunately, reality is not so simple. To be sure, there have been periods in which the market has remained fairly flat, along with the volatility index, but XIV has not made a profit. For instance, last summer the market remained flat from July to September but XIV lost about 5% during that period. This weakness comes from the fact that XIV buys additional VIX futures when they increase in value and sells more VIX futures when they decrease in value. This inefficient operation of buying high and selling low is dictated by the primary goal of the ETF, which is to replicate the inverse of VIX on a daily basis. To make a long story short, XIV has to buy high and sell low on a daily basis just to accomplish its official goal and this handicap can fully or partly offset its profit from contango, depending on the magnitude of the daily moves of VIX. While this is an important handicap that has not been mentioned in any article, the main weakness of XIV is its extremely high risk. More specifically, when the market experiences a significant correction, XIV collapses. For instance, while the S&P lost 16% in the summer of 2011, XIV lost 71% during that period, plunging from 19 to 5.5. This is an extreme loss, particularly given that it resulted from a normal market correction of just 16%. It would be interesting to check the performance of XIV during the bear market of 2008 or the flash crash but unfortunately (?) the ETF was introduced only in late 2010. Nevertheless, as a 16% market correction led to a 71% dive of XIV, it is reasonable to assume that the bear market of 2008, with a total loss of about 55%, would have destroyed XIV. Indeed the issuer of XIV explicitly warns investors that the ETF can go to zero on a single day (!) with extreme volatility. Therefore, the ETF holders should not use it as a long-term part of their portfolio but only as a hedging instrument on a small scale. To sum up, XIV greatly profits from the contango structure of VIX futures, particularly in a strong bull market like the ongoing bull market of the last 6 years. However, the ETF is obliged to buy high and sell low only to accomplish its stated goal of replicating the inverse of VIX. Even worse, the ETF will be completely devastated on a single day with extreme volatility or during a strong bear market. Therefore, investors should weigh the risk/reward ratio before initiating a position in this ETF. 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.

Frustrated Yet?

The last year has been a tough one for investors. There are a few places one could have booked a double-digit gain in the last 12 months but not many and certainly not in assets that are in the standard portfolio. Currency hedged ETFs for European and Japanese stocks produced big gains, but a lot of the gain was from nothing but currency movements. And most investors shouldn’t be trying to make their yearly return punting on currencies. Stocks for the most part have been disappointing with Nasdaq as a notable exception. Notable because a lot of the action there is reminiscent of the last time that index was leading the market back in 1999/2000. The recent big moves in Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Netflix (NASDAQ: NFLX ) and Amazon (NASDAQ: AMZN ) – based on not much – provided a eerie sense of deja vu for anyone who lived through that giddy time. The S&P 500 over the last six months is barely positive, up about 2% (or it is as I write this Friday afternoon; but if things keep going in the current direction, that could be a lot closer to 0 by the close). The average doesn’t do justice to what is really going on though. Only about half the stocks in the S&P 500 are trading above their 200-day moving average right now. Even for an index like the Nasdaq that has performed pretty well this year, less than half the stocks in the index are still in uptrends, trading above their 200-day MA. These are capitalization weighted indexes and at least right now, size does seem to matter. A similar message is sent by the advance/decline stats which show the decliners winning by a pretty wide margin. New highs/new lows also looks less than healthy with new highs increasingly scarce. So the internals of the stock market are deteriorating notably, something that doesn’t generally bode well for the immediate future for stock prices. There are other signs of stress as well. Junk bonds essentially peaked almost a year ago in price and have been trading sideways with a downward bias which has recently accelerated. With Treasuries generally well bid all week, the spread between junk and Treasury yields widened on the week, continuing the longer-term trend that started last summer and reversing the shorter-term narrowing trend that started at the beginning of this year. Credit spreads are highly correlated with the stock market, so ignore the junk market at your portfolio’s peril. Other signs of stress have emerged over the last couple of weeks. Commodities have resumed their downtrend and unlike some other recent periods, it isn’t just a function of a rising dollar. The dollar has been fairly steady but was down last week even as gold and other commodities plumbed new lows for the move. Oil is breaking toward its lows and that is undoubtedly the source of at least some of the selling in the junk bond market. The fracking companies are still struggling and lower prices aren’t going to help them make their interest payments now that their hedges are expiring. The Treasury market also is pointing to some stress with inflation and growth expectations both falling a bit recently. The frustration of the diversified investor actually goes back quite a bit further than the last 6 months or last year. If you have been following an investment plan that includes international stocks and bonds, a smattering of commodities and/or anything else that isn’t US stocks, your personal pain is now running into more like two years and maybe a bit more. I track a long list of passive portfolios and many of the globally diversified ones are working on their third consecutive year of low-to-mid single-digit returns – assuming this year turns out to have a positive number. It isn’t just the US stock indexes that have been narrowing; it is the entire investment universe. This winnowing of the investment universe to a few winners, turning diversification into a risk factor, is just one more example of the negative consequences of the modern form of economics in which common sense has been relegated to quaint notion and nonsense elevated to learned discourse. It is an Orwellian discipline where borrowing and spending have replaced thrift and investment as the drivers of economic growth, prudence is punished, speculation celebrated and rewarded. Is it any wonder that our economy continues to struggle when we’ve spent decades urging the population to be irresponsible, to ignore the future so that our present can be more comfortable? Monetary policy is a cudgel, a blunt tool used for more than a mere nudge, to make investors feel obliged to chase returns, to take excessive risks to achieve even their mundane goals. If you can’t achieve those goals with safe investments – and economic policy has made that nigh on impossible – you move out on the risk scale until you can because the alternative – spending less, saving more – has been deemed un-American, economically unpatriotic. The unspoken agreement – unspoken by the Fed certainly but widely accepted and believed – is that the monetary powers that be will maintain risky assets at the high prices that have, according to the Fed, produced or at least enhanced whatever meager recovery we’ve had since 2009. A permanently high plateau , if you will. The problem is that this unspoken agreement, this economic wink and a nod, has produced moral hazard on an epic scale. People do stupid things when they think their rewards are deserved and any losses will be absorbed or prevented by others. If you doubt that, just take a few moments to remember the structure of the mortgage system that produced the last crisis. It was a system where government policy didn’t just implicitly relieve lenders of the risks of their loans, they did it explicitly by either guaranteeing the loans or buying them outright. Now we apply that lesson to all investors, the Fed equally concerned about the stock index and the price index. It has “worked” so far in that risky asset prices are high but the economic payoff is less clear. It may be that the US and global economy is better off today than it would have been without the exertions of the world’s central bankers, but you’d be hard pressed to prove it. Considering the moral lessons being taught by these policies one can’t help but wonder if the gains are worth the potential losses. Markets, individuals, will eventually see through the Fed’s illusion of control and mark assets to a real market. The list of winning investments – risky investments – has been pared down to just a few over the last two years and the list gets shorter every day. Most recently the junk bond market has been quietly deleted or at least partially erased from the winners list. With oil prices falling again, the fracking companies bankers are balking of course, but it isn’t just energy companies that are being denied financing. Several deals have been canceled recently that had nothing to do with fracking. And it isn’t just junk bonds that are getting marked down; the high grade corporate bond ETF (NYSEARCA: LQD ) has actually performed worse than its junk bond cousin over the last six months. You certainly can’t call it a credit crunch yet but the new normal economy may not need a full blown crunch to fall into recession. It is a frustrating time for investors and one that is fraught with danger. The risk isn’t from without, from some unknown black swan, but rather from within, from ourselves, the self-inflicted financial wound caused by greed and the very American desire to win, to do better than the next guy. It is tempting to discard the investment methods that have withstood the test of time in favor of the fad of the moment, the church of what’s working now. But in every investment cycle there comes a time when winning is accomplished by not losing, by ignoring the sirens of risk and lashing oneself to the mast of safety. Now would seem a good time to at least find the rope.

Why Capital Allocation Matters

Summary Despite being a direct factor of long-term investor returns, few investors actually focus on identifying management teams that allocate capital well. Empirical studies suggest that even most management teams do not fully understand the importance of capital allocation on their business. The “holy grail” in investing is to find an excellent business, trading at a discount to fair value with a management team that allocates capital well. Introduction: Capital allocation is a topic of great importance to investors and management teams. At the core of any business is the simplistic NPV/IRR model which is used to answer a very simple question: Where should we invest? Whether a company invests in a new factory or an individual invests in a security, the concept is the same: If I outlay an amount today, how much will I expect to get in return in the future. Capital allocation in its simplest form is allocating capital from its various sources to its highest return. As author William Thorndike argued in his work, ” The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success ,” the goal of a CEO is to properly allocate capital to its next highest return. The argument for such a quantitative measure of success is in stark contrast to the numerous more qualitative theories to excellent management. This article will focus on the goals of capital allocation and how an investor should logically assess the decisions management teams and Boards of Directors are making in regards to capital allocation decisions. As I previously mentioned in an older article, over long periods of time, compounding at higher rates creates exponential differences in ending values. Just like with investing, allocating capital in projects at high rates of return won’t matter as much in the short term but will matter tremendously in long term. Why Capital Allocation Matters: Capital allocation is the most critical aspect to generating long-term investment returns, yet despite many management teams making mention of the topic, their track record remains poor. A recent article posted in the HBR made a record of faults of current CEOs and their lack of focus on capital allocation. This is despite the fact that much of the financial theory regarding how value in a firm is created was first theorized in 1960s. So why do most CEOs perform poorly at what is arguably the most important for their position? A powerful argument, aptly discussed by legendary investor Warren Buffett in his 1987 Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) Annual Letter, is that CEOs are more popularity contest than aptitude test. CEOs usually come up through the ranks of a company’s most important divisions such as sales, marketing, R&D or engineering. Their background and skill set is completely different as compared to what is actually required of them when they are promoted to CEO. This mismatch between a CEO’s background and the expectation for proper capital allocation by a firm’s investors has created the basis for typical activist investing. For all investors, the matter is still paramount when making investing decisions, especially those that are long term in nature. For the same exact business, excellent capital allocation will deliver excellent shareholder returns while poor capital allocation will do the opposite. How to Assess Capital Allocation Decisions: Management teams have a basic toolbox of decisions they can make to generate returns. The equation itself is relatively straightforward. First, capital can be obtained in four ways, the sale of debt, the sale of equity, the sale of assets and through internally generated operating cash flow. Next, the capital can be allocated in five different ways, either the issuance of dividends, the repurchase of stock, the retirement of debt, the purchase of other assets (M&A) or the reinvestment back into the business (i.e. Capex or net working capital additions.) Among each of these decisions, no specific one has precedence over the others. This is a critical concept that few investors or management teams truly appreciate. Whether capital is obtained through issuing debt or through operating cash flow, the capital is still finite and should be treated as such. A common misconception that many management teams and investors have is their view that operating cash flow is free and costless. This is not true as its real cost is the opportunity cost of other projects that could be done with the cash. Investors have been and should be upset when a management team uses operating cash flow to spend it on new internal projects with poor prospects of sufficient returns. Lastly, the question of capital allocation is not cut and dry. The best answer a management team could give investors regarding their view on capital allocation is: “it depends.” A common answer by some management teams might be to first spend on the business itself (new Capex or R&D) then pay a dividend and then use the rest of the excess capital for share repurchases. The graph below depicts this concept as share repurchases tend to peak during cyclical economic peaks, when operating cash flows are at their highest levels. (click to enlarge) This decision process is flawed, however, because capital should be allocated towards its next highest return. When a business is earning very high returns in its core business, reinvestment makes sense but if incremental returns are slowing, the company should not spend more despite the prospects of the business growing future revenues and profits. If the share price is substantially undervalued, the company should forego cash dividends and instead repurchase stock. If the share price is extremely expensive, M&A multiples far too high and all reinvestment opportunities exhausted, the last resort for management should be to pay a special cash dividend. This kind of flexibility in decision making may make investors nervous or less likely to buy a stock but it is the correct mindset for management teams who wish to drive attractive long-term shareholder returns. Finding Management Teams with Good Capital Allocation Skills: How does one find which management teams are apt at capital allocation? First, assess how a company’s management team discusses and presents its view on capital allocation. Does management think growth in the business should come at all costs? Are they beholden to a cash dividend no matter what other options for capital allocation exist? Do they not have an internal hurdle rate for returns when they do an M&A transaction? These types of viewpoints are indicative of a management team that does not have a solid grasp on proper capital allocation. Good management teams will describe the financial reasoning for their decisions. For example, for an M&A transaction, mentioning of the multiple to EBITDA or cash flow and how the deal is accretive to EPS and attractive on an ROIC basis are all needed to be sure the management team is doing due diligence. If a company is making share repurchases, they should make mention of their view on how undervalued the shares are. If the company is making share repurchases no matter what the multiple of the stock is to EPS or FCF, that is a telltale sign that management isn’t focused on capital allocation. Conclusion: Investors should be very wary of management teams and their capital allocation skills. Many CEOs move up through a company in divisions that don’t train them in proper capital allocation, leaving them less than apt at making investors above average shareholder returns. By staying focused on how management teams allocate capital, investors can figure out whether their investments’ management teams are making capital allocation decisions that maximize future shareholder returns. 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.