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Understanding The Sources Of The Volatility Risk Premium

By Wei Ge, Ph.D., CFA, Senior Researcher, Parametric The volatility risk premium, also known as the volatility risk premium, refers to the observed phenomenon that option-implied volatility tends to exceed realized volatility of the same underlying asset over time, thus creating a profit opportunity for the volatility sellers 1 . This difference is most apparent in broad market equity indices such as the S&P 500 Index. For example, the implied volatility of S&P 500 Index options has exceeded the realized index volatility 85% of the time from January 1990 to September 2014 (shown in Figure 1). If options were priced at their fair theoretical value, the volatility embedded in options prices should, on average, be very close to the subsequent “realized” volatility of the S&P 5002. However, options have historically traded about 4.4 percentage points above subsequent realized volatility. Said another way, the option market tends to overestimate future volatility, which means that options prices tend to trade with an embedded risk premium. 3 (click to enlarge) Click to enlarge This paper surveys the literature on the volatility risk premium and identifies three commonly accepted sources of the premium: behavioral biases of investors, economic factors, and structural constraints (Figure 2). The first source is the behavior of investors, namely, risk aversion, loss aversion, and availability bias-psychological heuristics developed through evolution for survival, but not necessarily suitable for the modern global financial marketplace. These behavioral biases then translate into financial and economic patterns that reinforce such premia. And a third source of this risk premium is found within market structural constraints, which can lead to a dearth of volatility sellers and cause an imbalance of buyers and sellers. The volatility risk premium, then, results from a combination of these behavioral, economic and structural factors. Its presence has been stable across time and is likely to persist in the future. (click to enlarge) Click to enlarge There are several possible ways to monetize the volatility risk premium, including option strategies (selling calls, selling puts, selling straddles or strangles), swap strategies (selling volatility or variance swaps), or futures strategies (trading VIX futures). Such strategies are not without risks though, and attempting to monetize the volatility risk premium is not suitable for all investors. However, investors with long-term investment horizons, including institutional investors or high net worth individuals, who are willing, and able to bear the unique risks involved, may be in a good position to take advantage of the volatility risk premium and potentially harvest superior risk-adjusted long-term returns for their portfolios 5 . BEHAVIORAL BASIS OF THE VOLATILITY PREMIUM The ultimate behavioral bias is risk aversion. Humans hate uncertainty. Given the choice of two investments with equal expected returns, one with no volatility and the other with significant return volatility, most investors will choose the former. Most investors are even willing to sacrifice a certain amount of return in exchange for potentially more stable return streams. This preference for greater certainty of returns is generally the most important source of the volatility risk premium. Risk aversion may be evolutionary in origin. Early humans lived in a perilous world where all types of dangers were lethal, including carnivorous predators, harsh conditions, natural disasters and invisible pathogens. The trait of risk aversion may provide a significant competitive advantage in the race for survival, and kept our ancestors away from harm’s way. In this way, risk aversion may be seen as ingrained in investors’ DNA. Loss aversion is another intrinsic bias for most investors. People are recognized to feel much more pain from losses than joy from gains, and to behave in ways that minimize potential losses, even at the expense of foregoing large potential gains. The psychologist Daniel Kahneman, one of the founders of behavioral finance, once found that to persuade people to play a simple coin toss betting game, the gain must be more than $20 to off-set the possible loss of $10. This phenomenon is nicely summarized in Figure 3. (click to enlarge) Click to enlarge Starting with an understanding of people’s aversions to risk and loss, it follows naturally that when people are presented the possible payout curves for long or short option positions, they will strongly favor the long option positions of either calls or puts (Figure 4) that offer limited downside and large potential upside. Buying out-of-the-money put options appears naturally more valuable to investors since they offer investors protection on the downside when they face potential large losses, and act like the financial equivalent of insurance policies. Out-of-the-money call options have potential value since they embody potential large winnings with small premiums, becoming the financial equivalent of lottery tickets. Few investors want to be on the short side of either call or put option trades due to the limited upside and potentially large downside consequences. Because there are large numbers of potential buyers and few potential sellers, somewhat counterintuitively, the economic law of supply and demand allows short options, and especially put options, to demand significant premiums in order for market demand to balance. (click to enlarge) Click to enlarge Another explanation for the large premium on put options may be the fact that put selling has long been stigmatized as a gambler’s game. This bad reputation is probably justified due to the risk of a large potential payout associated with a short put position. This stigma is reinforced by the fact that the big payout may happen exactly when funds are needed the most by investors, during a crisis, and at the same time as all other assets in a portfolio are losing money. The economic law of supply and demand stipulates, again, that such a stigmatized trade can demand a significant premium for its associated risks. The next behavioral bias that may further increase investors’ appetite for long options is the availability heuristic, which states that people tend to judge the importance of events based on the ease with which such events are recalled. Some events are recalled with great vividness and strong sentiments, negative events such as the Global Financial Crisis, Black Monday, and September 11, 2001 (many of us still remember every single detail of that morning). On the upside, the IPOs of Facebook (NASDAQ: FB ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), or any other high flying stocks are still fresh in the minds of many investors. Such events weigh disproportionally high in our decision-making process. Many investors demand downside protection due to the enormous fear such crises evoke in their minds, or seek to participate in the rise of another miracle company, regardless of the actual probability that such events may ever happen again in the marketplace. Lastly, the research reveals that people simply cannot grasp very small probabilities or other extreme numbers (Figure 5). They tend to overestimate their chances of winning the next Power Ball (approximately 1 in 200 million) or dying in a plane crash (approximately 1 in 50 million), which makes selling lottery tickets and air travel insurance profitable businesses. The blanket media coverage of lottery winners or plane crashes further strengthens this tendency, because of the impact of the availability bias. The public tends to value perfection, and any small deviation from a 100% score or a 0% error is thus given more attention than warranted. In the stock market, the Black Monday type of loss has (down 22.61% in one day) only happened once in history. But since it happened, people are constantly fretting when the next Black Monday will happen. The persistence of the volatility risk premium reflects this concern. (click to enlarge) Click to enlarge All market participants are human beings with human emotions, such as hope, greed, fear, excitement, dismay, frustration, etc. The market trends and prices are inevitably affected by such human emotions and the tendency to be risk averse, effectively preserving the continued good health of the volatility risk premium. ECONOMIC FACTORS Stock price dynamics include not only small incremental changes (random walks), but also the possibility of sudden and large price jumps. Option strategies can be designed to offer protection against unfavorable price movements and the premiums include coverage for both types of movements. The coverage against jump risk includes participation in a sudden upward jump (lottery tickets) or protection from a downward jump (disaster insurance). The potential for lottery ticket style returns are large for call options on some individual stocks due to the nature of the underlying business (such as small growth firms) but are less prominent for put options 8 . While index level movements are similar to the dynamics of individual stocks, sudden upward jumps are relatively rare for indices. Purchasing equity index put options, especially out-of-the money options, helps to “insure” buyers from market meltdowns, which is valuable for most investors. Disasters do happen in the marketplace and the threat is very real for all market participants. Everyone remembers Black Monday, the Great Depression, and the more recent Global Financial Crisis, but no one can predict when the next disaster will strike. One measure asset managers can take to protect their portfolios is to purchase insurance against this unpredictable possibility. This search for protection creates significant demand in the market place for index put options. Index put options may appear cheap, costing less than $10 to $15 each for a potential payout of hundreds of dollars, but actually they are quite expensive in terms of the implied risk. Like tsunamis or large earthquakes, stock market disasters actually happen very rarely. For example, even during the two years of the Global Financial Crisis (July 2007 to June 2009), there were only two months that the S&P 500 Index suffered losses of more than 10% (October 2008 and February 2009) and put option prices were also at their most expensive levels during this time. Alternatively, the volatility risk premium can be viewed as compensation for bearing certain undesirable return/risk profiles. Besides jump risk and tail risk, correlation risk is another feared risk 9 . Losses in the portfolio can accelerate when correlations converge to one. Some argue that the main driver for the higher volatility risk premium for index put options is the increased correlation both within the index and between asset classes. The payout of short put options shows a negative skewness and a concave payout profile. This is the most detested return profile for investors due to our natural aversion to losses 10 . Compensation must be high for bearing such unwelcome risk factors. The range of premiums and payouts for option contracts can vary widely, and thus carry very different utility functions for investors. The premiums paid are usually small and do not represent a significant burden for buyers. The payouts of options that are exercised are usually much larger and carry much more weight in people’s minds. For example, the payout for call options usually happens when the market experiences upswings, investors are optimistic, market players are willing to lend, liquidity is abundant, and the utility of such an expected payout is relatively low. In contrast, the payout of put options usually occurs when the market is in a crisis mode, when prices of other risky assets are plummeting, when liquidity is scarce and market participants are unwilling to lend, and when many firms are worried about their balance sheets or even potential bankruptcies. The purchase of a put option represents the frantic search for protection when it is most precious and needed the most. Thus, put option sellers can be viewed as liquidity providers of the last resort. Liquidity at this moment is such a precious resource that promises for providing it warrants a significant premium. Constrained liquidity availability during a crisis also creates a high threshold for volatility selling investors. Only a select group of investors can afford to take the role of the liquidity provider during a crisis. Such investors usually have stable sources of cash flows that are less affected by the economic cycle, e.g. endowments, foundations, pension funds, sovereign wealth funds and high net worth individuals. Those who can embrace the role of liquidity provider of the last resort get richly rewarded for providing this precious service for other investors during a financial crisis. MARKET STRUCTURAL CONSTRAINTS The asymmetric payout profiles of long and short positions of option contracts can generate many potential buyers, but few natural sellers. As the economic law of supply and demand generally stipulates, the short positions must carry significant premiums for the market to balance between the two sides of the equation. Who are the option buyers and sellers? Option buyers can be divided into two groups, hedgers and speculators. Speculators are investors betting on market directions and wishing to profit from the movements. In comparison with betting on market indices, buying options may offer some advantages. For example, potential loss is limited to the premiums paid vs. potentially unlimited losses. Hedgers are usually asset managers who seek downside hedging positions to protect their portfolios. When asset managers are concerned about possible market downturns, put options potentially become convenient insurance instruments. Since there are many asset managers, and as a group they invest trillions of assets that may need protection, this class of hedging forms a potentially large basis for put option buyers. After the Global Financial Crisis, the concept of downside protection, especially protection against tail risk, became popular among asset managers, maintaining a huge market for volatility products. In comparison, the potential pool for option sellers is much smaller. Option market makers sell options but they usually seek to make money from bid-ask spreads and they are not systematically betting on volatility. Though they may accumulate net short positions due to the higher demand for long option positions by the customers, it is not their intention to make money from shorting volatility. They may hedge away the market directional risks embedded in their net option positions. Option selling may be perceived as a new investment strategy that is utilized primarily by sophisticated investors, and is classified as an alternative investment, which may further limit the potential number of sellers and the overall asset size for short positions. For example, a typical large multi-asset portfolio may have a 40% allocation to equity, 40% to fixed income, 10% to commodities, 5% to real estate, and only 5% allocation to other alternative investments. Of the 5% alternative allocation, the bulk may be allocated to “traditional” alternatives such as hedge funds or private equity, and maybe less than a percent to a volatility selling program, if any. On the other hand, many hedge funds may be utilizing option shorting strategies. When we compare the entire 40% allocation to equity that may need protection with the small allocation to option selling or related hedge fund strategies, we can more clearly see the impact of this essential imbalance between buyers and sellers of options. Furthermore, when comparing put selling with call selling of index options, call selling may be a more attractive choice for many investors than put selling. Though call selling has the risk of potentially unlimited loss, large upward jumps are potentially very rare for equity indices. The payout of a call option happens when there is liquidity in the market. Any losses from shorting calls can potentially be offset by the gains in the equity portion of the portfolio if the call selling strategy is a part of a larger portfolio. Put selling, in contrast, faces many more obstacles. Because of the stigma associated with put selling (“conventional wisdom”), many investors may not even consider put selling as an investment strategy. The policy constraints of many mandates may also prevent investors from becoming put sellers. In recent years, writing call options has gained some traction in the market as a viable investment strategy. 11 However, writing put options is a strategy that few are intrepid enough for, and the premiums embedded in put options are still significant, making it an unconventional but potentially attractive investment opportunity. 12 When we view the proposition of option selling (especially puts) from an asset manager’s point of view, we may find it associated with great career risk for the manager personally. If the market rallies and the trade goes well, they may still need to explain why they took the risk and why (they believe) the profit will persist in the future. On the other hand, if a crisis hits and the strategy suffers the initial losses (before the heightened premiums pull the strategy back above water), the manager may be blamed for the losses and risks being fired. On the other hand, if they are long options as a protective measure, few will blame them for buying insurance for portfolios, even though it is very expensive. John Maynard Keynes once commented on this unique risk for managers: “It is better for reputation to fail conventionally than to succeed unconventionally.” 13 A PERSONAL ANECDOTE: BUYING EARTHQUAKE INSURANCE IN CHICAGO I used to live in Chicago and when I bought a house in a nice suburb of the city, the property insurance salesperson asked me if I would like an earthquake add-on to the insurance policy. I was not a geology expert but I did understand that earthquakes tend to happen at the edges of tectonic plates. Chicago, located in the center of the North American Plate, is unlikely to experience the large earthquakes that happen in Japan or California. I even checked the detailed seismology records and found that the worst earthquake Chicago ever experienced in 250 years happened in 1909 and the only damage was a few chimneys in a remote town almost 30 miles from city limits. Given metro Chicago is virtually earthquake free, I expected the earthquake add-on to be fairly cheap. But to my surprise, it was very expensive and constituted a sizable portion of the whole property insurance. Naturally, I said, “No.” To my wife’s and my own surprise, I changed my mind the very next day and purchased the earthquake insurance after all. Why? First, the vivid images of devastating earthquakes are seared into our minds and will always pop up whenever an earthquake is mentioned (availability bias). Do you remember the images from the disastrous 2010 Haiti earthquake, or the 2011 Japanese earthquake and tsunami, or the 2008 Sichuan earthquake of China? No matter how small the chance of earthquake in Chicago, the threat of an earthquake never seems to be far away. Better safe than sorry! Second, financially, when I thought about the cash flows of my family, the premium for the earthquake insurance constituted only a tiny portion of the annual budget and had almost no effect on the cash flows. However, if an earthquake does happen, liquidity will become very scarce for my family and the prospect of cash availability in such an emergency certainly sounds attractive. Third, economically speaking, the utility of the premium for me was almost zero during normal times and when cash was abundant. However, the economic utility of the insurance payout would be priceless when my family was facing a certain financial ruin if earthquake did happen, no matter how unlikely it was. Also, it is unlikely I can get help from friends or neighbors when an earthquake does happen in Chicago as they will face the same problems. In the end, even though I knew very clearly that earthquakes were as unlikely as ever in Chicago and the insurer was literally collecting (almost) free money, I still purchased the policy. The insurer was acting as a potential liquidity provider when cash is in urgent need and both parties of the transaction knew this clearly. When I think about this experience, I can relate to put option buyers in the market place. Granted, there are no free lunches in the market and any potential returns should be balanced against commensurate risk. But there are risks that only a few are willing and able to bear, and those who do will expect to be rewarded richly. CONCLUSION: WHEN A LARGE EARTHQUAKE STRIKES CHICAGO Consider the following thought experiment. Imagine an unlikely event such as a large earthquake striking Chicago. Will the earthquake insurers be wiped out if this happens? Very counter-intuitively, the answer is a likely no! Of course, the insurers will face an initial loss due to the large-scale payouts for existing earthquake policyholders. The payout will be limited by the fact that there are not a lot of earthquake policyholders in Chicago. On the other hand, the premiums for earthquake insurance will skyrocket, and at the same time everyone will swarm to purchase policies. The insurers will likely make a fortune instead because of the increased demand and higher premiums, and future earthquakes remain as unlikely as before, since Chicago is still located in the center of the North American tectonic plate. This is somewhat analogous to the performance of a put selling strategy during the Global Financial Crisis (Figure 6). As the market entered a tailspin in September of 2008, a systematic put selling strategy suffered initial losses comparable to the initial claims of an earthquake policy. However, in contrast to conventional wisdom, as fear prevailed in the market place, the volatility risk premium skyrocketed and the put selling strategy recovered quickly. The maximum drawdown happened months earlier than the S&P 500 Index, and the put selling strategy recovered lost ground in just half a year. In contrast it took the S&P 500 Index five and half years to come back to its pre-crisis peak level. 14 (click to enlarge) Click to enlarge Source: Parametric (Jan 2007 to Dec 2009)15; Date: April 15, 2013 Hypothetical performance is for illustrative purposes only, does not represent actual returns of any investor, and may not be relied upon for investment decisions. Actual client returns will vary. All investments are subject to loss. Please refer to the Disclosure included on page 11 for further information. Many investors question the validity of the volatility risk premium and these questions are quite reasonable. For example, certain trading strategies accumulate steady small gains with very low volatility but may incur disastrous losses, though with a small probability 16 . This aspect is certainly true prior to 2008 as the Global Financial Crisis showed the magnitude of the potential headwinds. Volatility selling, however, is not a static strategy but a dynamic one. Old contracts expire and new contracts are initiated. Our research and empirical experience show that volatility selling strategies tend to be more profitable during or immediately after a financial crisis. Some critics have tried to simplify the volatility risk premium as compensation for unconventional risks such as increased correlations in a crisis, the negative skewness of the payoff, and the overall concave payout curve of volatility shorting strategies. We agree with this explanation and believe that it is an important reason behind the volatility risk premium, but it is by no means the full explanation. The volatility risk premium is a complex phenomenon and there are multiple drivers behind it, as this paper tries to explain. We want to point out that the premiums garnered for taking such risks are predominantly caused by investors’ behavioral biases in the form of overestimating price movements, and the structural constraints in the market, namely the natural imbalance between options buyer and sellers. It is important to emphasize again that monetizing the volatility risk premium in portfolios is not appropriate for all investors, but generally only for those investors with long investment horizons and adequate resources, who are less liquidity-constrained during times of market stress. The potential rewards for those who take on risk are generally driven by supply and demand in the market place, and when a crisis does hit, the contrarian investors and the well-resourced players should expect to be rewarded for providing financial assistance when it is most valued. Investment strategies designed to harvest the insurance risk premium should be utilized throughout the market cycle. The expected premium is usually higher when the market is in turmoil. However, as no one can time the market successfully, investors should or may want to consider having exposure to a volatility risk premium harvesting strategy at all times. The benefits of such a strategy include its simplicity, transparency, liquidity, and the expectation that the insurance risk premium will continue to exist in the markets. Investors who take on this unique risk premium thus should expect to benefit from it in good times and bad. REFERENCES Bakshi, G., & Kapadia, N. (2003). Delta-Hedged Gains and the Negative Market Volatility Risk Premium. Review of Financial Studies, 527. Bakshi, G., & Kapadia, N. (2003). Volatility Risk Premiums Embedded in Individual Equity Options: Some New Insights. Journal of Derivatives, 45-54. Bollerslev, T., & Todorov, V. (2011). Tails, Fears, and Risk Premia. Journal of Finance, 2165. Bondarenko, O. (2003). Why are put options so expensive. Working Paper. Cowan, D., & Wilderman, S. (2011). Re-Thinking Risk: What the Beta Puzzle Tells Us about Investing. GMO White Paper. Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 1-25. Gonzalez, R., & Wu, G. (1999). On the Shape of the Probability Weighting Function. Cognitive Psychology, 38, 129-166. Grant, K., Gregory, K., & Lui, J. (2007). Volatility as an Asset. Goldman Sachs White Paper. Ilmanen, A. (2011). Expected Returns. Wiley Finance. Israelov, R., & Nielsen, L. (2014). Covered Call Strategies: One Fact and Eight Myths. Financial Analysts Journal, Vol 70(6), 23-31. Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 263-291. Kahneman, D., Knetsch, J., & Thaler, R. (1991). Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. The Journal of Economic Perspectives, 5, 193-206. Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. Knupp, E. (2008). Evaluating the Performance Characteristics of the CBOE S&P 500 PutWrite Index. Ennis Knupp White Paper. Litterman, R. (2011). Who should hedge tail risk. Financial Analysts Journal, 6-11. McFarren, T. (2013). VIX Your Portfolio. BlackRock Investment Insight. Rennison, G. A., & Pedersen, N. K. (2012). The Volatility Risk Premium. PIMCO ViewPoint. NOTES 1 There are several reference articles explaining the insurance or volatility risk premium in depth: (Rennison & Pedersen, 2012) (McFarren, 2013) (Grant, Gregory, & Lui, 2007), and (Bakshi & Kapadia, 2003) 2 Some may argue that the implied volatility calculated from option prices are model driven and depend on the implicit assumptions of these models, and thus does not represent an unbiased expectation of future market volatility. However, implied volatility actually forms a “smile” shape when we plot implied volatilities against a range of different strike prices (the so-called Volatility Smile) due to the “fat-tail” of return distributions. Because of this, the VIX index is constructed to give an unbiased gauge of the market expectation on volatility for the next 30 days using a range of option prices (taking volatility smile into account). The insurance risk premium is easily observed when by noting that the VIX index is typically higher than the following 1-month realized volatility of the S&P 500 index. It is generally accepted in the industry that VIX serves as an unbiased market gauge of future volatilities, as the effects of fat tails are incorporated into the calculation of VIX. 3 Some may argue that options prices can’t get too far from “true value” because there are natural ways for supply to be created – options replication is one. Please note we are not arguing that options prices are inefficient. They are simply rewards for unconventional return/risk profiles and only a small number of investors are able to undertake such return/risk profiles. 4 S&P 500 Index options relative valuation is measured by taking daily observations of implied volatility (the VIX Index) and subtracting the subsequent realized volatility of the S&P 500 over the following 30 days. VIX is the Chicago Board Options Exchange volatility index. 5 See (Litterman, 2011) 6 Figure 3 shows the main finding of the Prospect Theory. People generally value gains and losses very differently, with the pains from losses hurt much more than the joys over gains. The diagram shows that the utility of gain/loss shows an asymmetric S curve, with the lower portion (losses) much larger in magnitude. See (Kahneman & Tversky, 1979) 7 Figure 5 is a generic illustration based on the Prospect Theory by Daniel Kahneman and Amos Tversky. The graph shows that small deviation from a base state (0% or 100% probability) is usually given more weights in human decisions than warranted by probability. As a result, lottery prices are usually much higher than their true values implied by winning probability and insurance premiums for small probability events are also much higher than the true values implied by the probability of losses. 8 See (Bakshi & Kapadia, 2003b) and (Ilmanen, 2011) for discussion of insurance risk premium in individual names. 9 See (Ilmanen, 2011) for a detailed review and discussion. 10 See (Cowan & Wilderman, 2011) and (Frazzini & Pedersen, 2014) for a nice introduction. 11 See (Israelov & Nielsen, 2014) 12 See (Bondarenko, 2003) and (Bollerslev & Todorov, 2011) for discussions. The conclusions should still be relevant today as the phenomenon discussed is persistent in nature. 13 See (Keynes, 1936) 14 See also the returns of the CBOE PutWrite Index (Knupp, 2008). 15 Figure 6 is based on a proprietary Parametric put selling model strategy. The strategy sells 20% delta put options that expire in one month and is fully collateralized with cash instruments. Returns provided net of 30 bps model fee and expected transaction costs. 16 This is referred to in economics as a “peso problem.” The statistics based on the steady return streams thus does not account for the potential for huge losses.

Lies, Damned Lies, Corporate ‘Earnings’ And Up Markets

Summary Corporate earnings aren’t always what they seem. The loudest headlines often give the wrong impression. We prefer to stick with oversold value, like those we suggest below…. ” The stock market is never obvious, It is designed to fool most of the people, most of the time.” – Famed market trader Jesse Livermore One thing the market volatility of 2015 has done is decimate some of our best-laid plans, like owning hedges like QID into monster earnings from the QQQ stalwarts like Amazon (NASDAQ: AMZN ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Facebook (NASDAQ: FB ), Microsoft (NASDAQ: MSFT ) and Apple (NASDAQ: AAPL ). But on the good side it has also opened up some amazing opportunities, punishing brilliantly-run companies with great revenue and earnings potential just because they were in the wrong sector at a time when the markets’ primary participants wanted something other than what they offer. For the year thus far, for instance, that means New Tech / Social Media and Consumer Discretionary. So while Amazon, Google, Apple, Microsoft, Facebook et al have been on a tear, financials, utilities, most health care (particularly the high-tech biotechnology subset,) industrials, materials, consumer staples, utilities and energy are down for the year. That’s six of the original nine S&P sectors of our economy! (S&P just added two new sectors this month.) The V-shaped rally of October lifted health care to a 1.7% gain for the year, but the others are all still in the red. It’s important to recognize this because, in this too-much-data world we live in, people tend to be swayed by the biggest headlines, like the one recently on Marketwatch.com, proclaiming “Stock indexes enjoy best month since 2011” and think, “Wow, the market must really be up this year!” Not exactly. Even after October’s 8.8% rally, the S&P 500 is down 1.7% as of Friday, November 13th. For those who prefer the Blue Chips, alas, you are still down even more. I would rather see it up 2000 but, regrettably, facts are facts. This same “recency versus primacy” bias prevails in looking at individual companies’ shares, abetted by Wall Street’s desire to paint a rosy picture on the most ugly of earnings reports. They do this in two ways; first, by constantly lowering their “estimates” of earnings growth until they are certain that most companies will easily surpass expectations, and second, by ignoring massive losses as long as they are “non-recurring.” As to the first, suffice it to say that, if at the beginning of the quarter, success is measured as a 6-foot high-jump, but that is consistently lowered to a 5, then, a 4, then a 2-foot high jump, it is hardly exceptional to call it a high-jump when it requires only a simple step-over. The less transparent but equally deceptive practice is to say, “After non-recurring items, the company made a profit of x .” If the company, say, sells a money-losing division or abandons a major project, the losses incurred in so doing are considered “non-recurring” and therefore not germane to future earnings flow. Two brief examples: Johnson & Johnson (NYSE: JNJ ) is a longtime favorite of ours (we currently own it via our Tekla Healthcare fund.) The company released earnings for the 3rd quarter that most analysts gushed were a continuation of JNJ’s 4 consecutive quarters of “positive earnings surprises.” I have a problem with considering this the end-point of analyzing JNJ’s numbers. First, they once again showed less revenue this quarter. Earnings can easily be manipulated; revenue not so much. A company is either selling more of its products and services or they are not. One of the more popular ways to manipulate earnings is to buy back shares of your own stock rather than invest in R&D or customer acquisition. JNJ just announced another stock buyback going forward of up to $10 billion. This when its share price is within 10% of the highest it has ever been since the company’s founding in 1886. Second, JNJ only cleared the earnings hurdle after divesting itself of a smaller division at a loss, or as the WSJ put it, “Excluding special items, the company said it earned…” This “”excluding special items” clause also helped us decide to keep only a token amount in our family accounts of our once and future favorite, Royal Dutch Shell (NYSE: RDS.B ), which, every quarter it seems, takes a “one time” non-recurring action like $2.6 billion this past quarter to abandon its Arctic drilling exploration and another $2 billion to abandon its oil sands project in western Canada. The bottom line on these “one time” write-offs that companies take is: who knows how many other skeletons lurk in their closet for the next quarter and the quarter after that? More importantly, does it matter where the loss comes from? A loss is a loss is a loss. It means there is less money available to grow the firm going forward. In the first quarter of this year, my firm’s biggest and longest-served client died and his children have now effectively frozen the portfolio squabbling in court over who gets what. Did I say, “Oh, well, it was a non-recurring event so our real earnings to pay salaries, pay for research, etc. is untouched?” Of course not! And if you live in an older home in California and don’t have earthquake insurance and The Big One moves the remaining pieces of your home a quarter mile from its foundation, do you tell your family, “Wow! Aren’t we lucky that was a non-recurring loss?” As a result of financial chicanery I have become less trusting of corporate “earnings” over the years. The whole stock buyback house of cards may bolster earnings per share by reducing the shares outstanding – and will also keep the stock price high (a boon to the few executives in the inner circle whose bonuses are tied partly to the price of the shares) but what really matters in securities analysis? If you are looking for growth, to me that means two things: growth in top line revenues and growth in bottom line earnings, unadjusted for “impairments, special items, divestitures, the high price of the US dollar” or any other thing. Just because a company makes less money because the dollar is strong – it still makes less money . This leaves us with a conundrum. Of the companies out there that are growing real revenues and real earnings, AMZN sells for nearly 3 times sales and 894 times what are likely real earnings, GOOG at 6.5 times sales and 40 times earnings, and FB at 19 times sales and 104 times earnings. Fortunately, AAPL and MSFT are still possibilities and we have indeed begun to nibble at AAPL. But at this point, it simply doesn’t make sense to chase the high tech darlings in social media, online sales or cloud computing — with one against the grain exception. We are nibbling at stodgy old IBM, which has reinvented itself so many times over the past century that, especially at these prices, we aren’t going to count it out! If you can maintain a long-term viewpoint and avoid the emotion that inevitably accompanies volatile markets such as this one, I believe you will enjoy remarkable gains from these overlooked gems. We don’t need to chase the few already high-priced tech darlings to find hi-tech. Every sector and industry uses technology to increase its productivity and revenue. It is these innovators that use technology wisely that we are buying today – for profits tomorrow. There is high tech in industrials, materials, energy, health care and every other sector; it is seen in the ways in which productivity is enhanced and costs reduced. If we can buy stellar companies performing well in their business (but not seeing it reflected in their stock prices) at well below our assessment of their fair value, over any reasonable time frame we will do much better than we would by chasing the currently-highest-momentum Wall Street darlings that need just one mis-step to drop 31.8% in a week. [See: Netflix (NASDAQ: NFLX ) chart Aug 17 to 24…] Energy High Tech Last month I advised we were moving out of most of our RDS.B and BP (NYSE: BP ) positions to begin initial positions instead in Chevron (NYSE: CVX ), Range Resources (NYSE: RRC ) and Antero Resources (NYSE: AR ). Chevron is cutting-edge in LNG production and Range and Antero use technologies that didn’t exist a year ago to extract natural gas at lower cost than most of their peers. Yet all are held back by yet another decline in the price paid for their product. The reason? Projections are for a mild early part of winter. Somebody isn’t thinking very far ahead. We bought these 3 because we like their long term growth. Here at Lake Tahoe, we’ve just had our first snow (it’s so beautiful!) but for most of the nation, early winter temps are expected to be pretty mild – see chart below. But then… (click to enlarge) …look out below! Like I said, somebody isn’t thinking very far ahead. While we are early in our projection for the long-term recovery for natural gas, I think prices will rise short term as utilities start getting their contracts in place for January to March. You and I aren’t the only ones studying the meteorological soothsayers’ reports right about now. Buy your straw hats in the fall and, if you are a Southern, Midwest or Northern US utility, get your natural gas lined up while you can. If these projections for winter are accurate and the rig counts and drilling continue to decline, our 3 natural gas favorites will be ideal for both a short-term blip and, better still, long term profits. Materials High Tech As of last week, the Materials sector was down 8.6% for the year. We’re talking iron and steel, aluminum, chemicals, copper, and other basics of manufacturing and industrial processes. With manufacturing moribund of late, we might expect these sorts of firms to be dead in the water. But all things regress to the mean at some point. I think great companies like duPont (NYSE: DD ) and Alcoa (AA,) while some of their products have become commoditized, are always on the cutting edge of new uses for their products. Alcoa has two primary markets: automobiles and aerospace. Lighter cars, using much more aluminum, mean better gas mileage. Defense and commercial air are both in growth mode and both need what Alcoa provides. For its part, duPont is no longer just a chemicals company. Like IBM (NYSE: IBM ), DD has become expert at reinventing itself. It is now a major factor in agriculture, in biosciences and in human and animal nutrition. Not your father’s Oldsmobile, is it? Teflon, Tyvek, Lycra, Kevlar – all advanced-level materials turned into now-familiar products, all invented and/or developed by duPont. Today, while still pursuing R&D in many areas, agriculture takes center stage at DD. With more and more hungry mouths to feed in the world and less and less arable land available, crop yield becomes critical. Providing hybrid seeds that are more pest-resistant or higher-yielding from the same level of water and nutrients will provide outsize profits to those who succeed in this area. Allegheny Technologies (NYSE: ATI ) and Carpenter Technology (NYSE: CRS ) are also in the boring manufacturing and materials sector. ATI is the Big Dog in producing airframes and other components for military and commercial aircraft engines. Their titanium- and nickel-based alloys are the best in the business and offer reduced weight and greater strength for future aerospace products. If you believe, as I do, that commercial aviation and military defense are growth industries, ATI is a great way to play it without worrying about revenue per passenger and all the other “stuff” the airlines deal with. Carpenter sells to the same end customers in aviation and energy production as ATI does, but they specialize in very different components they construct from their high-value alloys and specialty metals. In fact, CRS specializes in products designed to withstand extreme heat, pressure and corrosion. The next time you fly, just imagine the pressure, weight and heat the landing gear of your aircraft must withstand; that is just one product that CRS specializes in. Real Estate High Tech Real estate? What could possibly be high tech about real estate? Glad you asked. We may take for granted that we pull out our mobile phone and are handily connected to family, friends, and business contacts across the street or around the world, but that doesn’t happen because there are mystical forces in the ether that connect our calls. No, that job falls to the nearly 200,000 cell towers that dot the globe’s landscape, without which Verizon (NYSE: VZ ), AT&T (NYSE: T ), T-Mobile (NASDAQ: TMUS ) et al would be dead in the water. You think high tech is merely the latest gee-gaw on a smartphone? I say the stealth play in mobile telephones are the biggest cell tower owners, American Tower (NYSE: AMT ), SBA Comms (NASDAQ: SBAC ) and Crown Castle Intl (NYSE: CCI ) Of these I think CCI stands head and shoulders above the rest. It’s #2 in number of locations but most heavily concentrated in US urban areas, which garner the most traffic. And it pays a 3.7% dividend to go with what I believe is excellent future growth. As long as people continue to use cell phones, the tower operators will profit. Not Forgetting Our Hedges… 2015 has thus far fulfilled our expectation from January that we have entered a more volatile phase in this aging bull market, yet we recently had our head handed to us by owning short ETFs like QID et al. What to do? We have researched a number of long/short mutual funds and ETFs. One is the global version of our highly successful (MUTF: BPRRX ). Boston Partners Global Long/Short (MUTF: BGRSX ) gives us the same quality team in the global area. Burnham Financial Long/Short (MUTF: BURFX ) focuses almost exclusively on financials. This is an area where some companies regularly disappoint and others soar. In short, if the research at BURFX is good, the profits are good. They’ve averaged 9.4% a year for 10 years. We are buying both. Disclaimer: As Registered Investment Advisors, we believe it is essential to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as “personalized” investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded! We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

The 4 ETFs That Will Replace My Portfolio’s Core

Summary All of the ETFs mentioned have annual expenses under 0.15%. The ETFs mentioned will allow broad based diversification for my portfolio’s core. These offerings are from Vanguard, but several other low cost fund families exist. Nearly two years ago I wrote an article entitled My Retirement Portfolio Could Be Replaced With These 5 ETFs . At the time, the article was written basically to as an alternative concept to my portfolio (at that time) of individual stocks. We all tend to evolve as investors over time. Each of us are on our own journey, whether we’re talking about investing or life in general. I know the focus of my life has evolved over the past few years. If you are interested in a summary my family’s journey thus far, read about it HERE . Over the past 2 years I have come to two important realizations, which encourage me to eventually rotate mostly out of individual stocks and to the portfolio outlined below. First and most importantly, there simply aren’t that many companies around the world that deserve my family’s capital. To be clear, I don’t mean there aren’t some reasonable values in the global equity markets. I am talking about companies that are so well run, and have amazingly sustainable competitive advantages, that I would commit to owning these companies for the next 20 or 30 years. Perhaps you think the idea of holding an investment for decades is a simplistic and illogical consideration, but I contend that it’s exactly my intention when I invest in an individual company on the “long-term side” of our bifurcated portfolio . For that reason, in the future I will cap individual stock investments at 25% or 30% of our portfolio’s value. It will be limited to companies that can compound my capital, and unlock value, for decades and I think those are few and far between. The second consideration in proposing the portfolio outlined below, is my personal time commitment . Currently I have a day job and enjoy researching our individual stock investments, but we are moving toward semi retirement. I anticipate additional flexibility and travel in semi retirement, but I can’t allow the time commitments of monitoring a portfolio of individual stock investments to get in the way our flexibility/freedom. That sounds too much like work. With those two considerations in mind, let’s take a look at the ETF offerings below. (Note: the funds discussed are all Vanguard offerings, but there are also other low cost fund families to consider like Fidelity and T. Rowe Price. Vanguard Total Stock Market ETF (NYSEARCA: VTI ) First up is Vanguard’s Total Stock Market ETF, my proxy for exposure to domestic US companies. In the previous article I mentioned Vanguard’s S&P 500 ETF (NYSEARCA: VOO ). Several readers commented that Vanguard’s Total Stock Market ETF might be a better alternative, because it includes both small and mid capitalization companies. After some thought, I agree. While this ETF is capitalization weighted, which in this case means it’s heavily skewed toward the large cap companies of the S&P 500, it also gives me some exposure to the small and mid capitalization companies. I like the concept of this additional exposure, because the small and mid capitalization companies tend to be much more isolated from international troubles and get nearly all of their business within the United States. I like to think of this ETF as the S&P 500, with a little extra kick. Given so much diversification, it’s hard to beat the annual expense ratio of 0.05%. Below is a snap shot of Vanguard’s Total Stock Market ETF, from Vanguard’s website. The companies in the portfolio represent a wide variety of industries. (click to enlarge) Vanguard FTSE All World ex US ETF (NYSEARCA: VEU ) The next ETF would be Vanguard’s FTSE All World ex US ETF. This fund includes stock in more than 2500 different companies around the world. The holdings are skewed to the largest capitalization companies, because of the fund’s capitalization weighting. Also as a result of the fund’s weighting, you probably recognize all of the names in the top 10 portfolio holdings. (Think Nestle ( OTCPK:NSRGY ), Royal Dutch Shell (NYSE: RDS.A ), Toyota (NYSE: TM ), and Unilever (NYSE: UL )). In the graphic below, courtesy of Vanguard’s website, you can see that this truly is a global fund. This is the type of diversification I expect from a capitalization weighted all world fund. Additionally, if you don’t feel comfortable having a large weighting of emerging market companies in your portfolio you may be able to hit your desired asset allocation within the 17.5% of this fund that represents companies located in emerging market economies. The annual expense ratio of this fund is only 0.14%, which is paltry considering the diversification (and rebalancing efforts) achieved by owning this fund. (click to enlarge) Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) If you are optimistic about the future of emerging market economies, you may want to add additional exposure to your portfolio by including something like Vanguard’s FTSE Emerging Markets ETF. I own this fund, but be warned that everyone has a different definition of what an “emerging market” economy is. Some people think of frontier economies, like those found in Africa and the Middle East. Others think of countries like Brazil, Russia, India and China. I’m not here to tell you what the right answer is, but remember that some emerging market economies have been “emerging” for decades. Remember to dig into your fund’s portfolio allocation, to be sure you are comfortable with what you are buying. (click to enlarge) See the table below for a perfect case in point. This is the geographic distribution of Vanguard’s FTSE Emerging Market ETF. A full 28.2% of the portfolio is comprised of businesses based in China, and 55.3 percent of the portfolio’s companies are based in China, Taiwan, or India. I would prefer if the percentage of companies from those three countries was reduced somewhat, but overall I feel the diversification achieved by this fund fits my family’s needs pretty well. For my annual expense ratio of 0.15%, I gain exposure to over 2500 different global companies. As a result of the difficulty gathering quality corporate information in many of these emerging economies, I have always used an ETF (and this one specifically) to purchase my desired allocation of emerging market companies. Vanguard Total Bond Market ETF (NYSEARCA: BND ) There is a conversation raging right now about whether or not bond investors are being adequately compensated for the risks present in the bond market. That’s a conversation for another day, although I will note that because I am still in my 30s and interest rates are so painfully low, I have not had any meaningful bond exposure in my portfolio for several years. Clearly this is an individual decision, and every investor is different. If however you would like exposure to more than 7700 bonds, for an annual expense ratio of 0.07%, Vanguard’s Total Bond Market ETF may be for you. As you can see in the three tables below, courtesy of Vanguard’s website, the vast majority of holdings are highly rated bonds. The bonds held in the portfolio are also from a variety of issuers and of varying duration. For simple and straight forward bond market exposure, Vanguard’s Total Bond Market ETF is worth a look. Specialty (Sector, County, and Asset) ETFs It’s amusing sometimes to look at all the different specialty ETFs and mutual funds currently being offered. While the typical investor has no need to invest in many of these funds, they are available if the investor so decides. Two specialty funds that come up in my conversations with readers are listed below, but rest assured that your own imagination is the only limit of fund offerings. If you want to invest in a socially responsible fund that only invests in women owned businesses in the former Soviet Union states, I’m sure there is a fund out there for you. I’m exaggerating to prove a point, but I assure you that there are literally thousands of specialty funds available to you, if you take the time to look for them. Remember that just because these funds exist, doesn’t mean they are worthy of your hard earned capital. Vanguard REIT ETF (NYSEARCA: VNQ ) In the current low interest rate environment, investors have been searching for yield anywhere they can get it. Many investors have turned to corporate dividends and distributions from REITs (real estate investment trusts) or MLPs (master limited partnerships). If you are interested in owning a basket of REITs, Vanguard’s REIT ETF may be for you. For a 0.12% annual expense ratio, you gain exposure to 140+ different REITs. In the graphic below (courtesy of Vanguard’s website) you can see the sector diversification offered within the fund, as well as the top ten fund holdings. (click to enlarge) Vanguard Healthcare ETF (NYSEARCA: VHT ) Many investors are keen to take advantage of long term trends, such as aging demographics, and global healthcare issues. If you are looking for this type of exposure, Vanguard’s Healthcare ETF is worth a look. For a low 0.12% annual expense ratio, you can gain exposure to over 330 companies within the healthcare industry. The distribution of those companies is shown in the graphic (courtesy of Vanguard’s website) below, as are the funds top portfolio holdings. (click to enlarge) In a future article I will write about my asset allocation goals for my portfolio, but I hope this article gave you an idea of several very sold ETFs offered within the Vanguard family of funds. (Other low cost fund families you may want to look at include Fidelity and T. Rowe Price). Given the impressive returns posted by equity markets around the world, I have been hesitant to shift all of our holdings over to passive index ETFs just yet. The reality is that I currently enjoy researching and picking individual stocks. Eventually I will not have the time, or desire, to spend so much time on our investments. At that time, having a core portfolio position in the group of ETFs mentioned here will be my best bet. I took an early step in that direction this summer, following China’s massive sell off, when began accumulating a large position in Vanguard’s Emerging Markets ETF. I still have a long way to go before I reach my desired asset allocations, but I am optimistic that better investment opportunities (and lower prices) will present themselves in the future. Do you hold index funds or ETFs in your portfolio? Why or why not? Disclosure: The only ETF mentioned that I currently own is VWO. I do own individual stocks included in some of the other ETFs. Please consult your investment professional to create an asset allocation mix that meets your specific needs. Mine is a fairly unusual case given my young age and mix of investment holdings. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any securities. I am not a financial professional. The information above is available at Vanguard.com.