Let the good times roll

So economic data continues to surprise to the upside in the US.  Better GDP, better employment, better corporate profits.  Articles are again popping up saying ‘no worries’ to continued rally in the S&P 500, as no one believes it.  

Guess the message is to keep the good times rolling in the stock market.  

I think back to office life in 2009: my colleagues were asking me ‘what stocks have you picked for your retirement account/portfolio?’.  My answer?  Anything.  When valuations were at those levels, you didn’t need to be a genius to find some good stocks (or just SPY) to invest.  

Nowadays??  Finding ‘value’ is much more difficult.  And as bond yields continue to fall, the risk-free hurdle rate goes lower and lower.  That means high P/E multiples can be justified by analysts, and savers/investors have to keep shifting to higher risk carry (e.g. dividends, FX carry, short volatility).

Why I love leveraged ETFs/ETNs…particularly UVXY

In a phrase: vol drag.

Volatility drag (‘vol drag’) is a product of compounding a return series which is multiplied by a constant.  In the case of UVXY, the return series is the movement in the VIX index, which is in turn a measure of S&P 500 30-day implied volatility.  The ETN aims to provide 200% of the daily change in the VIX index.

The immediate appeal of the product seems easy, at first glance: the VIX tends to move in opposite direction to the S&P, so why not buy VIX to hedge an equity portfolio.  While I’m at it, why not cut my hedging costs by buying a 2x version of the VIX?  Well, that’s where vol drag comes into play.

It’s important to mention that UVXY was, apparently, never created for investors holding more than 1 day.  Why?  Well, the first thing to mention is the VIX, like almost all underlyings, moves up and down: there is no smooth path for the VIX:

Screen Shot 2014-08-27 at 10.41.31

In fact, the VIX moves a lot: realised volatility for the VIX is around 125% these days, or around 8-10x the volatility of the S&P.  When we multiply that return series by 2, we increase the daily volatility by the same factor.  When we compound those returns daily, to make the price series for UVXY, we find a significant drag.  The difference between arithmetic returns (e.g. the 2x daily return achieved by UVXY) and geometric returns (e.g. the UVXY price series, which is a daily-compounded return series) is equivalent to 50% of the variance of the underlying (VIX), which is a big number.  See here for more explanation.

There’s another reason I love UVXY, which is persistent futures contango.  Because the VIX is not directly investable, UVXY invests in a combination of front & 2nd month VIX futures to achieve its objective.  The persistent contango is, ironically, likely a result of so many folks buying VIX ETFs/ETNs – more equity hedgers than speculators.  Anyway, because later-dated futures contracts cost more than nearer-dated, or indeed cash VIX, UVXY (and other VIX ETNs) have a persistent negative drag from the contango.

How does it all add up?  Here is YTD for UVXY versus its underlying, the VIX index.  A reminder: the objective of the ETN is to provide 200% of the daily return of the VIX; the persistent decay of UVXY is due to the factors explained above (in addition to a third, small, factor: a 0.75% annual management fee):

Screen Shot 2014-08-27 at 10.58.23

So, what to do with this?  The main risk to mention with UVXY is massive skew and kurtosis: that is, the very real risk for a large upward move when the VIX spikes.  So while I look at a picture like the above and say ‘Go short!’, I think back to times like 2011 where UVXY explodes both because of a spike in VIX, and because of a swift change in futures contango:

Screen Shot 2014-08-27 at 11.02.22

Yes, UVXY can blow up.  So, the answer is a combination of going short UVXY with buying upside protection.  If the protection can be bought reasonably (it usually can), and the investor can stomach the big jumps (knowing max loss from inception is helpful here), it seems a good trade.  Extra credit: wait for a VIX spike before opening a trade.  

(Source for charts was Google Finance)

On the reading list…

I’m now reading a book called Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance.  The general idea is to use relatively ‘normal’ return distributions (e.g. stock indices, as opposed to single stocks), combined with leverage (futures and options), to enhance portfolio returns.

I mentioned in an earlier post some life cycle portfolio research suggesting young people ( < 40 years old) use leverage to enhance stock returns.  This book, then, gives research on index selection and methods of leverage.  In general, I agree with the book’s main tenets for using leverage (from Chapter 1):

  1. Only use leverage if expected returns exceed costs of leverage.  Costs of leverage include interest, if using margin or other loans, or futures roll/lost dividends/extrinsic value for derivatives.
  2. Have enough cash or cash flow readily available to cover margin calls/interest. Simple idea here: the real risk of a leveraged portfolio is forced selling at a bottom, due to a margin call.  So keep enough cash around to cover that eventuality.  In my mind, this argues for using options rather than futures, and definitely rather than conventional margin.
  3. Loan terms will not require forced sale if underlying declines a significant amount.  Repetition, but worth it.  Again, in the retail world this would argue for option positions over futures or margin.

In our portfolio, I’ve mainly utilised bullish diagonal option spreads to replace long index positions.  This has the triple benefit of:

  1. Defining maximum loss (i.e. the net premium paid).
  2. Leveraging returns (e.g. notional value of the options position can be multiples of the underlying).
  3. Opportunity to profit from time decay and volatility increasing.

Hopefully the book will offer other methods to use options for index investing.

The cure for low prices is…low prices?

I’ve been following/trading the grains markets with interest these days.  A couple reasons:

  1. For some months, they actually had some volatility to sell, as opposed to equities, FX, and bonds.
  2. The best-of-all-time harvest theme runs through the press.  See this Bloomberg article, for example.

One of my dad’s old favourite sayings is ‘the cure for high prices is high prices’, at least when it comes to farming.  Farmers these days see the pricing, and plant accordingly.  So all these guys who planted corn last season, with prices up around $5, are now seeing record harvests and prices back down around $3.50.  Volatility, indeed.

Goes to show the path of technology, anyway.  Fewer and fewer farmers, producing bigger and bigger crops.  These lower food prices ought to help inflation, too.  

On Social Security

While I’m thinking of pensions…

I was talking to my mom the other day about Social Security.  It’s great that she listens to me on a soapbox.  In general:

  • Keep in mind Social Security was created in traditional nonsensical political style: the idea was hardly anyone would be entitled to benefits.  In 1937, the age to receive benefit was 65; the average life expectancy was about 60.  Demographics were definitely in the program’s favour, as there were about 40 workers paying into the scheme for each retiree.
  • The plan was never designed to be ‘forced savings’ in nature.  It is NOT a case of ‘Social Security is just giving back the money I put in, plus interest’.  The program is pay-as-you-go: today’s retirees are paid with the contributions of today’s workers.  
  • In the beginning of the program, there were about 40 workers paying into the scheme for each retiree.  Now there’s about 2-3 paying for each retiree, with this number expected to drop as Baby Boomers keep retiring.
  • The reserve fund of the program contains US Treasuries.  While these are supposedly ‘risk free’ assets, they are also future claims on US tax revenue.  Again, this is a pay-as-you-go system.
  • The reserve fund is being depleted, and Social Security finances are in doubt.  Benefits are unsustainable – either we raise retirement ages or taxes or both.
  • The key conclusion is I’m not convinced most folks in America understand that the millennials of America are being quietly asked/demanded/robbed to contribute to their parents’ retirements, when millennials will very likely either have much reduced or non-existent benefits themselves.  Not very headline grabbing, and not very vote-gathering for a society in which the beneficiaries vote much more than the payers.

End soapbox.

Take the company match?

I just heard this question asked again…. as a new employee, should I contribute to the company 401(k) or company pension, in order to get a company match?

This head-shaker is easy: YES.  For the avoidance of doubt, my strong opinion is:

  • Contribute at least as much as required to receive full match.
  • From there, consider contributing more: I have read in several places (Rational Expectations among them) that young folks need to contribute about 20% of salary to feel reasonably confident of a retirement in their late-60s.

Leverage for young folks

Reading Rational Expectations, I came across one really interesting portfolio management idea for life-cycle investing: leverage holdings at a young age.

This follows from research by Nalebuff-Ayres which runs a bit like:

  1. A young person generally begins her career with a lot of human capital (future earnings power) and near-zero financial capital (actual savings).
  2. The young person saves regularly towards retirement.  How should she invest her savings?
  3. With maximum human capital and minimal financial capital, the ‘right’ thing to do is leverage what financial capital is available, buying stocks on margin or using index option strategies.
  4. As the person ages, the leverage comes down, until it goes away in her 40s/50s.

I like this idea: buy stock index options as a youngster, so one can make a leveraged stock investment when one’s risk tolerance is highest.  Using options rather than margin loans means the maximum loss is limited to the amount paid for the options – you’ll never be called by the brokerage to put up more funds.  I’d further offset the implied interest rate on the index options (the extrinsic, or time, value of the option) by selling out of the money nearer-term options.  Oh wait, that’s what I’m doing!!