Tag Archives: financial

Neuroeconomics And Volatility

Summary Discussion on the summer spike in volatility in relation to the three areas of neuroeconomics. How your brain and emotions affect volatility decision making. I have preached patience and the science agrees. First, thank you for reading my articles. I have great readers, as shown by the comment sections of each article and I really appreciate all of you. If you enjoy my work, please follow me on Seeking Alpha and feel free to link to or share this article. In this piece, we will look into some very interesting research in economics and how that relates to volatility. Long-Term Volatility Trends I have always asserted that the VIX is driven long term by actual and predicted economic growth and short term by a variety of factors. If you look at the long-term chart below showing the VIX Index, you will see a slight correlation to the level of volatility and the performance of the general economy that generally agrees with this theory with a couple of exceptions. (click to enlarge) (click to enlarge) Let’s state the obvious here: if the economy is doing well or expected to be doing well, then volatility will tend to be lower and vice versa. This is a longer-term view of overall volatility. However, many other short-term events will produce better opportunities to profit from spikes in volatility when using VIX futures ETFs. Neuroeconomics This is something we haven’t discussed before in regards to volatility. This field of study seeks to explain human decision making, the ability to process multiple alternatives, and to follow a course of action. Neuroeconomics textbook definition fits very well into volatility trading. To compare volatility trading to neuroeconomics, we will use Jason Zweig’s book Your Money & Your Brain as a resource. Our First Lesson Monetary losses and gains are not just pure financial and psychological outcomes. These gains and losses create a biological change which has substantial effects on the brain and body. When trading volatility, it is important to understand and plan for the potential gains and losses of a given scenario. I am sure many people reading this article had been in a trade before and wondered things such as: how the heck can this be, this is out of control, the market is dumb, people are idiots, and then why did I even make that decision. On a daily basis, I see comments on social media that lend more to the premise of impulsive gambling rather than strategic investments in volatility. Areas of the brain linked to excitement and anxiety influence our financial decision making. Those decisions can be rational or irrational in nature. The nucleus accumbens is an area of the brain that activates when we expect a reward, such as a profitable volatility trade. Financial reward will most often cause traders to make decisions based on emotions and potential outcomes rather than the evidence at hand. According to Stanford University , the nucleus accumbens is located in an area of the brain rich in dopamine which has been linked to addiction. If you are only focusing on the reward of your volatility trade, you are leaving out 75% of the equation. How can you make a successful financial decision while encouraging your brain to release dopamine? Loss Aversion Loss aversion is the theory that individuals will exhibit greater sensitivity to losses than to an equivalent gain. I recommend reading The Neural Basis of Loss Aversion in Decision-Making Under Risk. In the past several years, investors have enjoyed above-average gains for an extended period of time. This pushed inverse volatility products such as the VelocityShares Daily Inverse VIX ST ETN (NASDAQ: XIV ) to new highs and leveraged long volatility products such as the ProShares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ) to new lows. It also created pockets of writers who openly touted inverse volatility products as the best trading vehicles ever (more on those results later). Let’s view a market chart and the performance of XIV from 2011 to mid-2014. It is important to note the Y axis in this chart and that the gains in XIV would have been 10x the amount of the S&P over this period of time. Graph mainly for illustration purposes of increasing gains. You can see that a clear upward trend was in place until July of 2014. Beyond that point, the market, although making new highs, began to get choppy and growth fears began to emerge exponentially in the media. See below for July 2014 to present including the VIX Index. This chart shows the percentage of change and is separated by equity to give you a clearer picture of each instrument. VIX Spike Why would the VIX Index, and subsequently the VIX futures which affect volatility ETFs, spike to a level not seen since 2008 despite the lack of an actual recession? The answer is loss aversion. Investors were less willing to lose $5 than they were to potentially gain $5 after so many years of steady gains. Hitting the sell button is easy when you are up substantially on your original position or you fall into a growing category of investors that have never experienced a market correction. There was also no shortage of dire news stories about the economy and slow global growth, further supporting the neurological decision to avoid risk. We have previously discussed how UVXY operates and its tracking of the VIX futures. You can read more about UVXY and other volatility products in the ETF Guide . When the VIX futures were spiking this past summer, UVXY went on a tear and produced incredible gains in a short period of time. See below: (click to enlarge) During this time period, you had incredible interest in UVXY mainly coming from news features and a huge spike in social media volume. Bandwagoners looking to make a quick buck were sucked in. Some got out ahead, and others didn’t. By the time some traders realized they had made a mistake, the natural dopamine had long worn off and reality started to set in. Although unfortunate for them, these traders are an essential part of the volatility food chain in which the patient and well positioned survive. Conclusion I hope you have enjoyed this first lesson on volatility trading in relation to neuroeconomics. I look forward to bringing you more lessons as my schedule permits. To recap, we discussed how chemical and physical changes in the brain due to gains and losses on your investments influence the decision-making process. As volatility traders, we can take advantage of this information by clearly seeing through the market turmoil and making decisions based on evidence (past and present) rather than emotion. By understanding the parameters that volatility futures will trade in, the usual highs and usual lows based on the current scenario and historical figures, you can plan out your trade to encompass the three areas of neuroeconomics. By weighing all possible scenarios, you can be better prepared to follow through with your trade and increase the chances of profitability. As we have discussed, our natural instinct is to sell and save rather than to wait and gain. If I could pick the most common word out of my volatility articles here on Seeking Alpha, it would be patience and the science behind your decision making agrees. For more information on volatility trading and its related ETFs along with strategies and educational series, please check out my library here on Seeking Alpha. As always, thank you for reading!

What Assets Should You Have In Your Moderate Portfolio?

With flat to slightly negative returns, one could make the case that the static Ibbotson model for diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines, the more one has been able to relax. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken, a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Ibbotson Associates provides asset allocation guidelines that span the risk spectrum from conservative to aggressive. The moderate portfolio consists of roughly 42% in U.S. Stock, 18% in Non-U.S. Stock, 35% Fixed Income and 5% in Cash. It follows that the static Ibbotson model might employ the following ETFs to achieve its moderate growth and income aim: With flat to slightly negative returns, one could make the case that diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines – high yield credit, emerging markets and smaller corporations – the more one has been able to relax. An allocation of 60% in large-cap U.S. stocks (NYSEARCA: SPY ) and 40% investment grade U.S. bonds (NYSEARCA: BND ) improved performance to 1.6% – a swing of 240 basis points. An argument in favor of diversification across asset class segments is that, if one holds recommended percentages for the next 20 years, recent underperformers will provide value down the road. Moreover, the combination of the above-mentioned asset types performed better than an ethnocentric large-cap-only allocation (60% S&P 500, 40% Barclays Aggregate Bond Index) over the previous 20 years. Here’s the problem: There are times when the breakdown in an asset grouping and/or an influential sector(s) of an economy is symptomatic of larger issues for market-based securities. For instance, the collapse of the banking system in 2008 had been telegraphed by financial stock woes nearly a year beforehand. The Financial Select Sector SPDR ETF (NYSEARCA: XLF ):S&P 500 SPDR Trust ETF ( SPY ) price ratio had been highlighting the rapid-fire demise of financial stocks relative to the broader benchmark. (Note: Back in 2007, “ex Financials” was the popular excuse offered to dismiss S&P 500 overvaluation; in 2015, many are using “ex Energy” to justify S&P 500 overvaluation.) There’s more. Even as SPY notched new record highs in October of 2007, other asset groupings did not recapture highs set in July of 2007. Small companies via the iShares Russell 2000 ETF (NYSEARCA: IWM ) did not make it back. In the fixed income space, preferred shares via the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) were weakening as well. In the last year of the previous bull market (2007), lightening up on smaller companies, higher-yielding preferred shares as well as the financial sector benefited investors. Here in 2015, lightening up on smaller company stock ( IWM ), foreign developed stock (NYSEARCA: EFA ), emerging markets (NYSEARCA: VWO ) and high yield bonds (NYSEARCA: HYG ) has also been beneficial. For one thing, each of these asset types sits below long-term 200-day averages – a bearish sign for these asset classifications. Secondly, even when one excludes energy from the high yield bond picture, “ex Energy” spreads have been diverging from the S&P 500 throughout the year. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. One might consider spreading the large-cap exposure across several ETFs such as the iShares Core S&P 500 ETF (NYSEARCA: IVV ), the iShares S&P 100 ETF (NYSEARCA: OEF ), the Technology Select Sector SPDR ETF (NYSEARCA: XLK ), the iShares Russell 1000 Growth ETF (NYSEARCA: IWF ) and iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). I have had virtually no allocation to small caps, high yield bonds or emerging market stocks during this late-stage bull market. All of those areas remain mired in long-term technical downtrends. In addition, I have only 25% allocated to investment grade bonds with another 15% in cash/cash equivalents. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken , a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Make no mistake about it… large-cap U.S. stocks are overpriced. Year-over-year, corporate earnings have fallen from a height of $106 on 9/30/2014 for the S&P 500 to the most recent estimate just shy of $91 (October 2015). That is a decline of approximately 14%. The earnings contraction over multiple quarters with the TTM P/E Ratio at 22.7 is well above the average since 1870 of 16.6. For those who would rather embrace Forward P/Es, Birinyi Associates at WSJ.com estimates a value of 17.4. This implies that $91 is going to be $121 in the next 12 months. Short of a miraculous revival in energy demand, 33% earnings growth is not particularly plausible. Even a forward P/E of 17.4 is 25% higher than the 35-year average forward P/E of 13. Overvaluation by itself is not a reason to reduce exposure to large caps. A late-stage bull market could continue for several more years; highly priced can become exorbitant. That said, if an economic slowdown becomes an economic standstill, and if the number of large company stocks holding up the market-cap weighted indexes further retrenches, reducing one’s overall equity profile and raising one’s cash level is sensible. Keep in mind, positions that haven’t been working (e.g., high yield bonds, small caps, emerging markets, etc.) will probably cause even greater pain when the market falls. It is critical to keep losses small. Similarly, it is constructive to exercise a methodical approach to raising cash as a late stage bull market carries on. Having some cash available is the way to purchase investments at a better price in the future. Indeed, there’s a reason that one of the premier rules for investing rule is “Sell High, Buy Low.” For Gary’s latest podcast, click here . Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

A Market Neutral Strategy To Profit From High Yield Bonds

Summary KKR Income Opportunities is a closed end fund that invests in high yield bonds and senior loans. While the 10.6% yield and the 14% discount to NAV may look tempting, some investors are worried about a continuation of the weak trend in this space. In this article I will present a market neutral strategy that can benefit from a compression in NAV discount while hedging a significant portion of the market risk. In a recent post I talked about the KKR Income Opportunities Fund (NYSE: KIO ) and how I found it attractive for income seeking investors. The biggest concern I have on that fund is the risk that weakness in high yield and leveraged loans may persist in 2016. In that case the 10% yield may be partially eroded by a declining NAV or a widening of the discount to NAV. For this reason I decided to dig further into this space and tried to devise a strategy that reduces the market risk while allowing investors to benefit from a reduction in the NAV discount. This strategy may be interesting for sophisticated investors that have access to and are familiar with the pros and cons of shorting. The strategy The strategy I have in mind involves going long KIO and at the same time hedging the position by shorting a combination of two related ETFs: the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA: HYG ) and the SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA: SRLN ). For more details on KIO I encourage you to read my previous post . Here I am going to give you a quick snapshot on HYG and SRLN before detailing the reason why I believe this strategy could deliver superior risk adjusted returns. HYG is an ETF that gives you exposure to US high yield bonds. It is very well diversified, with more than a thousand securities in the portfolio and a concentration of 4.7% of NAV in the top 10 names. The effective duration of the fund is 4.3 years while the total expense ratio is 0.5%. According to the latest fact sheet the credit rating breakdown is the following: SRLN is an ETF that gives you exposure to leveraged loans. It is less diversified than HYG with a total of 192 securities and has a concentration of 15% of NAV in the top 10 names. The average maturity is a bit less than 5 years but interest rate risk is minimal as loans are generally indexed to Libor. The total expense ratio is 0.7% and the most recent credit breakdown is the following: Analysis of the trade Considering that KIO is a fund that invests in high yield bonds and loans and is trading at approximately 15% discount to NAV I believe one could effectively short a combination of HYG and SRLN at prices close to NAV and go long KIO to take advantage of the mispricing. I would go short $1,500 of HYG + SRLN for each $1,000 in KIO to take into consideration the level of leverage in the KKR fund (a third of the assets are financed through a credit facility). The following analysis shows the NAV performance of $1,000 invested in KIO since the beginning of the year and compares it with the NAV performance of $1,500 invested in HYG +SRLN. The analysis includes the dividends distributed by all the funds. What you can see from the analysis above is that KIO outperformed both HYG and SRLN on a distribution adjusted basis in terms of NAV. I attribute a good part of that outperformance to the significant underweight in the energy sector of the KIO fund. Despite that, the stock performed poorly, down 12% for the year due to an increase in the NAV discount or down 4% after taking into consideration the distributions received. What to expect from the trade As you are short $1.5 for each $1 invested in KIO you are expected to “pay” a dividend cost of approximately 7.5% for your short: 5% is the average yield on HYG and SRLN and that needs to be multiplied by 1.5. This outflow will be more than compensated by a 10.6% dividend in KIO. All things staying the same and excluding tax considerations you net 3% and you are likely left with some spare cash given that you are shorting more than your long investment. In a positive scenario you can expect the NAV discount to reduce over time providing an additional source of profits. In terms of NAV performance you can expect a very similar development for your long and your short: KIO is a bit weaker in terms of average rating but has a lower exposure to the tricky energy sector. Some of you may ask a question: is this a pure arbitrage trade? I want to stress that this is not an arbitrage trade. Underlying securities in the two portfolios are different, sector weightings are different and portfolio concentration is different. However overall performance of the different assets should show a very strong correlation, with the main difference being that you buy a portfolio at a 15% discount and you sell a similar (but not identical) portfolio at par. Your biggest risk exposure lies in the possibility that the discount to NAV widens further in KIO. That should happen only in case of a new sharp drop in the value of the assets. I believe that would represent a great opportunity to cover my short at a profit and double down on KIO at an even cheaper valuation relative to the market value of its underlying assets and I would be more than willing to take that risk.