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Volatility Is An Asset Class That Can Be Sold As Well As Bought

By DailyAlts Staff The CBOE Volatility Index more than tripled during the course of trading on August 24, 2015 – an all-time record. On that same day, the S&P 500 fell nearly 4%, while the Barclays U.S. Aggregate Bond Index gained a miniscule 0.03%, demonstrating the ineffectiveness of the standard two asset class portfolio diversification model. Puny bond yields provide little cushion for broad market selloffs, which has led many investors to turn to alternative strategies and asset classes, including volatility itself. This is the subject of a new white paper from Allianz Global Investors (“Allianz GI”): Volatility as an Asset Class . Volatility: Realized vs. Implied The paper’s author, Dr. Bernhard Brunner, is Allianz GI’s Head of Analytics and Derivative. He begins by discussing the difference between realized volatility – the standard deviation of logarithmized returns; and implied volatility – that which is measured by the CBOE Volatility Index (VIX). Realized volatility is typically less than implied volatility, and this means buying implied volatility, such as through VIX futures, comes with a volatility risk premium . Thus, while the negative correlation between equities and equity volatility makes buying implied volatility seem like a good portfolio diversifier, the consistent volatility risk premium makes it even more attractive to sell volatility, according to Dr. Brunner. Variance Swaps In addition to taking short positions in VIX futures or ETPs that track volatility, investors can also sell volatility through so-called variance swaps . Variance swaps are traded “OTC” (“over the counter”), but swaps on equity indexes such as the S&P 500 and EuroStoxx 50 are highly liquid nonetheless. And while VIX futures may have considerable variance from realized volatility, variance swaps can be structured so their payoff is exactly equal to the difference between realized and implied variances, thereby constituting a more precise definition of the volatility risk premium. Allianz GI’s Approach Allianz GI has developed an index to earn the volatility risk premium by systematically selling variance swaps on the S&P 500 and EuroStoxx 50. Its investment approach is governed by specific rules and based on the following characteristics of volatility as an asset class: (click to enlarge) Volatility always reverts to its long-term mean; Volatility tends to bounce briefly when the stock market slumps, followed by lengthier downward trends; and Volatility forms volatility clusters. Volatility offers a lot of promise as an asset class, based on its portfolio-diversification advantages. Most notably, volatility has what Dr. Brunner describes as an “immunity to interest trends,” which makes it virtually unique among investible assets, and particularly attractive in the current investment environment. For more information, download a pdf copy of the white paper . Share this article with a colleague

Duke Energy Is A Good Play In This Volatile Market

Duke Energy is an electric power holding company whose stock is a low-risk investment. Despite its poor return on equity, Duke Energy has strengths that will continue to make it a reliable dividend stock. The company has performed poorly during the most recent quarter, but this is expected to improve. Duke Energy Corporation (NYSE: DUK ) is the largest electric power holding company in the United States and it is expected to stand firm in the electric utilities industry. Recently, the company has underperformed the industry average in many respects, causing its stock price to decrease from $89 to $70 within the past half year. However, an improvement in both company performance and market performance is anticipated. Duke Energy’s faults may currently overshadow its strengths, so it is important to dig deeper into the company’s operations and history before making a decision to buy. Insider Monkey shows that Luminus Management held onto about 1.68 million shares of DUK after decreasing its position by 22%. Seminole Capital’s position in DUK was slightly higher with 630,534 shares, while Highbridge Capital added a new position of 350,000 shares in DUK. We follow these funds because as Insider Monkey shows ( read the details here ), they have a penchant for making good long picks, but their short picks usually eat into their overall returns. In total, Insider Monkey showed five funds adding new positions in the shares of DUK and ten exiting their stakes. We think those funds staying long will not regret their decisions. Duke Energy has struggled with a YTD return of -12.19% even though its shares outstanding have decreased by 2.8% in the same time. The company’s gross margin of 42% exceeds the industry average, but its revenue has decreased over the past year, and in turn, DUK’s EPS has hit a recent low of $3.46. These disappointing statistics are troubling to investors, but there is plenty of reason to still consider DUK as a worthy investment. While many have lost faith in Duke Energy as of the most recent quarter, the company remains poised to reaffirm its reputation and generate a steady source of income for its shareholders. As the largest electric holding company in the country, Duke Energy has shown that its strengths will continue to make it an attractive opportunity for investors. With $120 billion or more in operating assets and nearly 8 million customer relationships , the company can ensure consistent operating cash flows and dividends. Its dividend yield is currently 4.49%. Slumping performance metrics are expected to improve in the near future as well. According to TheStreet , the market expects EPS to increase by $1.00 in the next year. With this may come a decrease in P/E ratio all else equal, meaning DUK may be undervalued considering its forecasted EPS. Additionally, NASDAQ shows DUK will realize earnings growth of 2.4% on a year-end basis and 5.28% by the end of 2016. DUK is known for its relatively consistent cash flows, but an improvement in performance may also be around the corner. Perhaps most important to investors, DUK is a low-risk stock, even compared to most other dividend stocks with an ultra-low beta of 0.35 on a 5-year basis. Its generally consistent performance is why the dividend has increased every year and the yield now stands at 4.5%. DUK remains an attractive option for risk-averse investors in that they have generated predictable cash flows through out their 150+ year existence, and its stock’s fortunes are not entirely tied to the market and the company’s fortunes are not entirely tied to the economy. Duke Energy’s two biggest direct competitors, American Electric Power Company (NYSE: AEP ) and CenterPoint Energy (NYSE: CNP ), have underperformed even more so than DUK. According to Yahoo Finance , AEP and CNP trail DUK in quarterly revenue growth, gross margins, operating margins, and EPS. The electric utilities industry in aggregate, however, has outperformed DUK in terms of quarterly revenue growth, perhaps due to the emergence of utility-scale solar developers. Otherwise, DUK seems to be in a far better position than its two largest direct competitors and the electric utilities industry as a whole. Duke Energy is a low-risk stock that may not offer grand price appreciation, but the company can provide shareholders with a steady source of income through dividends. Its position in the electric utilities industry, including its enormous portfolio of operating assets, allows cash flows to remain relatively predictable. Despite the disappointment surrounding recent performance metrics, DUK is still a reliable investment opportunity and can provide some stability in an increasingly volatile market. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

SCHD: Lower Volatility Than SPY, Lower International Correlations And A New Place In My Account

Summary SCHD offers investors less volatility than broad market ETFs. The holdings themselves are not extremely diversified, but the performance over the last several years shows the ETF maintains a lower correlation with other assets. I see some benefits to including a small position in SCHD while keeping the core in broad market ETFs. Lately I’ve been considering making some modifications to my portfolio strategy. As the market fell in August I had to recognize that I’m light on bonds. Of course, when the equity markets are falling and the bond markets are rallying it is precisely the worst possible time to start buying up the bond ETFs. Rather than focus on adding the bond ETFs right away, I’m working on revising my strategy. I’m looking for a portfolio that is easier to rebalance and shows less volatility with the market. One of the ETFs that I have been admiring for a long time is the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ). After the market started selling off hard in August, I decided it was time to look for a position in SCHD and put in a limit order to start buying SCHD. As I transfer more funds into the accounts, I expect to have SCHD regularly listed as a top contender for getting more buy orders and a higher allocation. Largest Holdings The internal diversification within the portfolio is much weaker than using whole market ETFs or broad market ETFs. However, the portfolio also has a lower level of volatility despite that challenge. The top holdings are shown below: (click to enlarge) The portfolio pays off a decent dividend yield, currently that yield is nearing 3% which seems fairly attractive as long term bonds are rallying. If we head into another recession, I want to be buying high quality stocks at lower prices (and higher yields) when the recession starts, when we are in the middle, and when it ends. One of the reasons I waited this long to get in on SCHD is that I was hoping for better prices and those seem to be coming through. My limit-buy orders are not very far out of the money and may have hit by the time the article is published. Expense Ratio The expense ratio on SCHD is .07%. That is low enough that I am happy to work with SCHD in my portfolio. Building the Portfolio I put together a hypothetical portfolio using only ETF’s that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) One quick thing to take away from this is that mixing SCHB and SCHX does not add any material amount of diversification within the portfolio. Investors could simply pick whether they prefer a broad market ETF or a focus on larger capitalization companies. On the other hand, SCHD does some add some diversification to either SCHB or SCHX. The core of my portfolio is currently whole market ETFs and broad market ETFs (including SCHB). I don’t expect that core to change, but I’m seeing SCHD post a correlation of “only” .95 with SCHB and a lower correlation with SCHC and SCHF which helps it provide some diversification. Despite the ETF being heavily focused on providing dividends, SCHD still posts a very negative correlation with bond ETFs. However, the negative correlation is weaker for SCHD than it is for the other equity ETFs. Since I may be using heavy rebalancing and allocating more to bonds over the next few years, I don’t want to go overboard on moving SCHD into the portfolio. I’ll probably limit my holdings to a range of around 5% to 10%. Conclusion SCHD is a very strong ETF for most investors. After admiring it from afar for quite a while I decided to take the plunge and put in an order to buy some shares if they kept getting cheaper. One of those orders activated earlier in the week. I put in another order to buy more if it drops again. The ETF offers lower correlation with some of the other holdings I’m using for international exposure or considering adding to the portfolio soon. Even though the internal diversification is not as great as broad market funds, the volatility has been lower and I’m more comfortable holding SCHD going into a rough macroeconomic environment. Disclosure: I am/we are long SCHB, SCHD, SCHH. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.