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Adoption Of VXUP As A Hedging Instrument Could Transform Investment Management

VXUP is revolutionary. VXUP could become a key hedge for non-correlated portfolios. VXUP deserves to become a billion-dollar ETF. Spot CBOE VIX Up Class Shares (NASDAQ: VXUP ) could transform investment management. While I am very empathetic to the notion put forth in yesterday’s article that the daily movement of the ETF currently lags the responsiveness of the raw VIX index, the recognition, appreciation, and acceptance of VXUP’s benefits should dramatically increase its trading volume. In turn, the increase in VXUP’s trading volume should make it much more responsive to changes in the raw VIX index. And this increased responsiveness to the raw VIX index will further increase the ETF’s value as a hedging tool, in a virtuous cycle. The general acceptance and adoption of VXUP as a hedging instrument should transform investment management in a variety of ways which I will specifically illustrate. Indeed, I believe that the investment community will quickly realize the immense profitability of promoting a very healthy level of liquidity and AUM in VXUP. Yesterday’s article did an excellent job of explaining VXUP’s mechanics, along with that of its inverse ETF VXDN (NASDAQ: VXDN ). I will not recreate the wheel here. However, I will point out numerous examples of strategies which could be vastly improved by the use of VXUP as a hedging component. Indeed, as a hedging instrument, it is totally irrelevant whether VXUP is perfect. What matters to the investor is whether or not VXUP is a drastic improvement over every other ETP hedging alternative currently available. I will argue forcefully that VXUP is vastly superior. The ZOMMA Index Master Sheet is an exhaustive list of ETP strategy indices and their variations that we have published on seekingalpha and sometimes in books. I forcefully argue that for any of the strategies which use iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA: VXZ ), iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ), or ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) as a hedging component, that the performance of those strategies could be vastly improved over multi-year periods by replacing the use of VXZ, VXX, and UVXY with VXUP. Theoretically, there are very short, discrete time periods where backwardation could benefit the use of VXZ, VXX, or UVXY. However, it has been definitively illustrated by dozens of studies that over longer times frames, persistent contango tends to cause an uncomfortable amount of performance drag when using these instruments as hedges. On one hand, I have argued that all of the strategies illustrated in the master sheet should no longer be used due to their correlation to long bonds. On the other hand, reducing the size of TMF, and making VXZ, VXX, or UVXY larger percentage allocations in an effort to reduce the strategies’ long bond correlation and diversify hedging sources kills upside performance due to contango lag–equally unacceptable. VXUP would solve this problem elegantly, allowing larger volatility-related hedges, which could reduce the correlation of the strategy indices to both stocks and to bonds, while eliminating contango lag. I have argued forcefully that the nightmare scenario for the financial markets is for both stocks and bonds to crash simultaneously. On 3/11/2015 , I wrote: The sad joke of financial markets is that they are driven by long term interest rates, which set the discount rate for all other asset classes. And indeed, dropping interest rates have made speculators of every stripe look brilliant. Imagine a high jumper who is constantly buoyed by a dropping force of gravity. His athletic prowess appears to be improving, but instead, the force of gravity is becoming weaker. And conversely, rising gravity, or interest rates, cause moving objects to drop to earth more quickly. Moving objects like stock prices, bonds, real estate, and even gold. Every asset class will be affected by rising rates. Since then, the TLT ETF has dropped from $127 to a touch below $117. Imagine a nightmare scenario is which both stocks and long bonds dropped by 50%, due to a spike in interest rates. In such a scenario, it is almost facile and axiomatic to point out that volatility would skyrocket. A hedge like VXUP would be absolutely essential to reduce a portfolio’s correlation to both stocks and to bonds during such a nightmare. Moreover, if stocks and bonds do not simultaneously collapse, a lower correlation to both asset classes will not hurt the investor seeking an authentically non-correlated return stream during more normal regimes. So returning to the issue at hand, the use of VXUP as a hedging tool potentially allows the serious investor to reduce a portfolio’s correlation to both stocks and to bonds without the continuous contango that a VXZ, VXX, or UVXY position would entail. And without contango, the new VXUP volatility hedge could be comparatively larger without the associated drag of pre-existing alternatives. So it is largely irrelevant to the serious investor whether or not VXUP perfectly mirrors the raw VIX index. No hedge is perfect. There are merely hedges which are far better than any available ETP alternative! And VXUP is that far better hedge. As the investment community realizes it and volume in the VXUP increases, ironically, the VXUP should better mirror the raw VIX and even further outpace the competition as the most serious tool in the hedger’s toolbox. The portfolio manager’s dream has always been a continuously traded put option of sorts, which can serve as a shock absorber to a portfolio, without the drawbacks of a put option’s time decay or a volatility future-based instrument’s contango (which some would call synthetic time decay). The VXUP should become that continuously traded put option. Nothing else which has been introduced in the ETF world comes close to the VXUP in achieving that goal. I am not an expert in ETF design, but the goal that VXUP seeks to achieve is exceedingly shrewd. I would argue that increased volume, AUM, and acceptance will make the instrument more robust, useful, and demanded. Disclosure: I am/we are long VXUP. (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.

You Could Short China At This Point, But It’s Not For The Fainthearted

Chinese stock markets could be set to fall by 50 percent. Given concerns of a stock market bubble in China, I take a bearish view on Chinese equities at this point in time. The ProShares Short FTSE China 50 ETF could potentially provide an opportunity to take advantage of a downturn. However, this strategy carries high risk given the degree of volatility inherent in Chinese stock markets. Once a booming economy at which a growth rate of below 8 percent annually was unheard of, things have certainly been changing for China in the past five years. Stock markets in China have certainly seen periods of abnormally high returns. However, such returns have come with significant volatility and sustained growth has remained elusive. For instance, the Shanghai Composite Index (000001.SS) has seen significantly high returns in the past year, up over 100 percent from the beginning of 2014 to May of this year. However, the trend now appears to be reversing, with the index having lost as much as 12 percent since the beginning of June, along with various experts predicting that the index could in fact fall by 50 percent. While I had previously commended China’s rise in stock prices and was optimistic on its continuation, I am less so in light of the recent volatility. Firstly, high stock market returns have not been matched by correspondingly high growth. China’s stock markets appear to have been taking a similar course as that of Europe, where quantitative easing and lower interest rates have forced investors to seek higher returns in the stock market. Moreover, this situation is being exacerbated in China given that returns from the property sector have been significantly lower than in previous years. In this context, I take a bearish view on China at this point in time. Given the historical nature of volatility across Chinese stock markets, the market appears to be at a significant risk of correction. This is especially possible given that stock returns are increasingly being driven by margin; i.e. investors are now borrowing to fund their positions. Should contagion develop in China and investors pull out their funds, then it is quite conceivable that a 50 percent drop would be possible under such circumstances. While a 50 percent drop seems rather drastic, it would not be that unusual when taking into account that the Shanghai Composite has already appreciated by over 100 percent in the past year. Moreover, China’s stock markets have precedent for demonstrating that they are not immune to contagion, with the Shanghai Composite having dropped almost 60 percent between 2007-08 in spite of higher economic growth rates above 8 percent at the time. Additionally, with China trading at a cyclically-adjusted price-earnings ratio of 20.5, this is significantly higher than the overall emerging markets ratio of 16.5. In this regard, China’s stock markets are likely overvalued and could be due for a pullback. While China’s quantitative easing has spurred increased investment in the stock market due to lower borrowing costs, this is unsustainable and there is always a risk of a sharp pullback in response to a rise in US interest rates, as investors seek more stable returns elsewhere. For investors wishing to take advantage of a specific short position on Chinese stock markets, one way of doing so is through the ProShares Short FTSE China 50 (NYSEARCA: YXI ), which has returned over 7 percent since the beginning of May. This ETF corresponds to the inverse of the FTSE/Xinhua China 50 Index and has succeeded in capturing a broad downturn in the Chinese market over the past two months. However, a significant risk remains in that investors would likely have to time the trade very well; returns on the ETF as a whole have been negative. Moreover, 5 of the 10 largest companies on the index originate from the financial sector. In this regard, it is likely that stock performance would move down in response to a broader economic downturn in China. However, with Chinese banks gaining traction internationally, it could be the case that this in fact lifts stock market performance higher. To conclude, I take an overall bearish view on the Chinese stock market at this point and a short opportunity likely exists. However, investors would likely endure significant volatility in doing so which would make this quite a risky trade. Disclaimer: Investing in emerging markets carries a high degree of volatility and as such, the above strategy is not recommended for conservative investors. 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.

Pepco-Exelon Merger: OPC-DC’s Position Raises Questions As To Agency’s Effectiveness, Relevancy

Summary The D.C. Public Service Commission is reviewing the Pepco-Exelon merger; regulatory approval is the final step in the process and if granted, the transaction should close shortly thereafter. Pepco shareholders will receive $27.25 per share in cash plus a pro-rata dividend; the D.C. AG and the Office of People’s Counsel D.C. have voiced opposition to the proposed merger. A closer look at the OPC-DC’s brief in opposition to merger reveals flawed reasoning and a motive of preserving the agency’s existence and relevancy to the detriment of D.C. consumers. We are approaching the conclusion of the regulatory review of the Pepco-Exelon merger which was announced on April 30, 2014. Pepco Holdings Inc.’s (NYSE: POM ) stock now trades ex-dividend (from June dividend) but there remains upside at its current price of $26.75 per share. At closing shareholders will receive $27.25 per share in all cash and a pro-rata dividend of $0.002967 per share per day after June 10th and until the merger closes as we discussed in early-June . We continue to hold our position in Pepco and expect that Exelon (NYSE: EXC ) will close the transaction in July with the expectation that the Public Service Commission of D.C. will grant its approval of merger. (click to enlarge) (Source: Nasdaq.com) The Office of the People’s Counsel of D.C. Is Taking the Wrong Approach to the Merger In anticipation of the Public Service Commission of D.C. vote to approve the proposed transaction, the Office of the People’s Counsel of D.C. filed a brief outlining their views and opposition to the merger. We are surprised that the OPC is taking strong stance against a sound merger that will result in a more efficient company with greater resources to provide reliable and low cost service to the people of D.C. Even more surprising is that their arguments against the proposed transaction are inconsistent and in many instances directly contradict past statements made by and official views of the OPC. We believe if Pepco continued as a standalone company over the long-term, Pepco’s already attenuated financial position may worsen due to the company’s substantial indebtedness, and capital expenditure requirements for further investments in infrastructure improvements. OPC has even agreed that this was true prior to the Exelon-Pepco merger. In Mayor Vincent Gray’s annual letter for OPC in 2013 he starts off by discussing how Pepco has struggled significantly with service reliability and minimizing power outages: (click to enlarge) (Source: OPC-DC 2013 Annual Report; opc-dc.gov) With such an unfortunate experience in service reliability, we would think the OPC would like to a see a service provider with greater financial strength, greater resources to invest in improved infrastructure, and an experienced and talented management team. This does not appear to be the case. In fact, OPC would like the opposite. We look to OPC’s brief on the merger and surprisingly the office now claims that “PHI/Pepco do not need Exelon” and “Direct Benefits to Ratepayers are Inadequate, Overstated, and Will Be Fully Realized (if at all) Only After Many Years.” Suddenly and inexplicably (actually we will get to our explanation below), Sandra Mattavous-Frye, the head of the OPC, in the brief put her full support behind Pepco CEO Joseph Rigby’s statement of service reliability: (click to enlarge) What could possibly explain this sudden shift in the OPC’s view toward Pepco? The OPC-DC relies upon power outages, unreliable service to its consumers and over-billing among other issues in order to litigate and justify its existence within the D.C. government. A standalone Pepco will allow OPC to continue to pursue litigation against Pepco and take advantage of power outages and poor service for political gain. For example, Sandra Mattavous-Frye states that in response to several consumer complaints against Pepco and other energy suppliers: “We took a novel approach to a traditional problem. We petitioned the Commission to investigate the matter, educated and informed consumers about their rights, and negotiated a global settlement with the provider. The end-result was an unprecedented settlement that addressed the needs of some 500 aggrieved customers and led to the creation of a $100,000 low income energy grant fund.” Apparently suing Pepco is a “novel approach.” But this is what the agency relies on and the agency continues to pursue litigation against Pepco and others when the opportunity arises. Any improvement in the underlying problems by more efficient and low cost service providers would disrupt the agency’s mission. Therefore, in an effort to maintain the status quo, the OPC has come out against the merger with populist views of how the merger is driven by greedy management and shareholders at the Illinois-based Exelon. Politically, this stance grabs headlines and gets strong support from a solid segment of the population but in the end, we think it is bad public policy for D.C. consumers and will not withstand the objective review of the D.C. Public Service Commission. We expect the D.C. Public Service Commission to approve the merger. (click to enlarge) (Source: Exelon Presentation April 30, 2014) In Our View, the Transaction Would Undoubtedly Be an Overall Positive for D.C. Consumers We believe the OPC’s vocal stance against the merger is driven by the agency’s self-interest as the merger will in effect render this inefficient, bureaucratic agency irrelevant. Consumer complaints will almost certainly decline and overall service reliability will improve post-transaction. (Source: OPC-DC.gov; 2013 Annual Report) Exelon’s establishment of a Customer Investment Fund and a commitment for enhanced reliability will improve the service for D.C. consumers over the status quo. Post-transaction, the agency’s role in advocating consumers will be greatly diminished and the D.C. government may take a close look at this agency to determine if it is even necessary to continue to spend significant and valued taxpayer dollars on such basic tasks when consumers are receiving low cost and reliable service from the new Exelon-Pepco entity. Will History Repeat Itself? In our view and final analysis, the Office of People’s Counsel DC provides very little, if any, substantive value to DC consumers. The agency represents government bureaucracy at its worst despite its claim that its overall budget is revenue neutral. (click to enlarge) (Source: OPC-DC.gov) We find that the agency is over-staffed and under-delivering on its mission to educate, advocate, and protect consumers because the agency is squandering its resources in pursuing misguided political activism at the expense of DC consumers. The office which was eliminated once before in 1952. After being reestablished in 1975, we think now in 2015 the agency’s effectiveness and relevancy has passed it by. Disclosure: I am/we are long POM. (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.