The Ultimate Hedge

Last summer I wrote about a seemingly expensive U.S. equity market and hypothesized that stocks would correct in the near future. I believed the S&P would pull back from all-time highs, but have watched stocks follow the select history of extended bull markets that persist in the upper quartile, if not decile, of valuations for a number of years. Regardless of my personal opinion that the S&P is due for a 15-20% correction (at least) in the next 12 months, in this post, I will rather discuss something that I perceive as an inevitability: increased volatility.

If you’ve followed the markets this summer, you know that US equities have continued their outperformance, most recently due to a strong earnings season. You also saw that healthy macroeconomic data, specifically jobs reports, almost eliminated any last sign of worry to be found on the street. Lastly, you watched US equities undergo historically low levels of volatility as measured by the CBOE VIX. Generally, when market activity is low, sentiment is calm or cautiously optimistic and the VIX decreases. When markets become more active, the VIX goes bananas. The VIX hovers around 12 now and has dipped below 9 this summer, its lowest levels since the early 1990s. For some perspective, the VIX surpassed 80 during the Great Recession. It’s a simple proposition, right? Buy volatility; market activity is bound to pick up especially in our late stage of this economic cycle. Sure, but be smart about it…

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5-year volatility as measured by the CBOE VIX Index (bloomberg)

First you have to endorse the hypothesis that something will happen. Anything. Geopolitical tension, forget military action, causes outflows from equities and inflows into ‘save haven’ assets including precious metals and fixed income. As the situation between the United States and North Korea escalated (and has since calmed), volatility increased while the markets reacted to growing geopolitical concerns (VIX spikes 40% on 8/10/17 as Trump issues statement guaranteeing American toughness in the event of an attack). And as quickly as the VIX rises, it falls (see chart above).

In addition to geopolitical concern, any disappointment in macroeconomic data could catalyze a correction, and almost certainly cause an increase in the VIX. Many investors shared my opinion last summer when I claimed equity markets were overvalued, but kept their stake in the game to participate in the ongoing upside. A minor catalyst such as a notable increase in unemployment due to greater labor participation could cause such investors to finally sell some of their equity position, and trigger an increase in the VIX.

Then there’s the passive/active debate. This is the first year since 2008 when >50% of active managers are expected to outperform their respective benchmarks. Think about what could happen if passive investment vehicles lose their appeal and experience considerable outflows: as much as investors have poured into Vanguard’s S&P 500 ETF (VOO, $340 billion in net assets), the more the outflows from passive investments could hammer the markets when those investors lose confidence. The passive bubble is a threat that few have seriously considered, and the VIX will spike if it bursts, whether catalyzed by macroeconomic data, a shift back to active management, or my flawless blog posts.

After believing the hypothesis that market activity will pick up, you have to time a VIX investment almost perfectly, and here’s why: there is no way to actually buy the VIX. There are ETFs and ETNs that track the VIX closely, but these products are based on futures contracts which can be exceedingly expensive depending on the street’s pricing on a given day. This means that the drag is significant; if the VIX is flat, these products lose value, some faster than others. The goal is to capture the upside, but be aware that you might lose big on the downside. And most of these financial vehicles aren’t cheap; few offer expense ratios below 100 basis points. It isn’t for the faint of heart.

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The drag, or recurring cost of futures contracts, of UVXY means it has lost 90.2% the last year. In fact, UVXY has had a number of reverse splits for this reason. But when it spikes, investors are rewarded if they sell at the right time. (Google)

My personal selection for exposure to the VIX is a double-levered product, UVXY (above). UVXY purchases daily (as opposed to monthly) VIX contracts, so the daily swings are exacerbated. The most popular product to gain exposure to the VIX is VXX, with over $1.2 billion in assets. VXX buys medium term contracts (monthly), and is not a levered product. I believe that if you experiment with something as risky as volatility, your downside will be very significant regardless of the financial product you select. You should be willing to lose everything, so justify this risk and maximize your upside with a levered product. Day traders will love this play, and if you are not a day trader, get ready to babysit your trading platform if taking advantage of this opportunity, as volatility itself is volatile.

 

PLEASE NOTE: EDWARD C. MCCANN DOES NOT BEAR ANY RESPONSIBILITY OR LIABILITY WITH RESPECT TO RESEARCH MADE AVAILABLE. INVESTORS SHOULD UNDERSTAND THAT THEY ASSUME FULL RESPONSIBILITY FOR ANY TRADING DECISIONS THEY MAKE BASED UPON THIRD-PARTY RATINGS OR REPORTS.
THE INVESTMENTS DISCUSSED HAVE VARYING DEGREES OF RISK, AND THERE IS ALWAYS THE POTENTIAL OF LOSING MONEY WHEN YOU INVEST IN SECURITIES. SOME OF THE RISKS INVOLVED WITH EQUITIES INCLUDE THE POSSIBILITY THAT THE VALUE OF THE STOCKS MAY FLUCTUATE IN RESPONSE TO EVENTS SPECIFIC TO THE COMPANIES OR MARKETS, AS WELL AS ECONOMIC, POLITICAL OR SOCIAL EVENTS IN THE U.S. OR ABROAD. INVESTMENTS FOCUSED IN A CERTAIN INDUSTRY MAY POSE ADDITIONAL RISK DUE TO LACK OF DIVERSIFICATION, INDUSTRY VOLATILITY, ECONOMIC TURMOIL, SUSCEPTIBILITY TO ECONOMIC, POLITICAL OR REGULATORY RISKS AND OTHER SECTOR CONCENTRATION RISKS.

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