With the huge inflow of asset under management into the ETFs, a natural question arises: how do ETFs influence the markets?
Opinions are diverse. Connected Wealth presented a nice report on Valuewalk and concluded:
The rise of passive investing, mainly via ETFs, appears to be
changing the structure of the markets. This could be supressing
individual company variance and making the market more macro driven. As
more money flows into passive ETFs, this structural change would likely
continue to rise over time. At some point this could be a big enough
driver to create greater opportunities for more fundamental research to
add value. Perhaps opportunities to take advantage of blanket basket
driven price moves. Not sure if we are there yet, but it is likely
coming. Read more
Other observers are more specific. Dani Burger wrote
Exchange-traded funds are making stock markets dumber — and more expensive. That’s the finding of researchers at Stanford University, Emory
University and the Interdisciplinary Center of Herzliya in Israel.
They’ve uncovered evidence that higher ownership of individual stocks by
ETFs widens the bid-ask spreads in those shares, making them more
expensive to trade and therefore less attractive. This phenomenon eventually turns stocks into drones that move in
lockstep with their industry. It makes life harder for traders seeking
informational edges by offering fewer opportunities to capitalize on
insights into earnings and other signals. The study is the latest to point out signs of diminished efficiency in markets increasingly overrun by the funds. Read more
Similarly, Charles Stein calls ETFs Weapons of Mass Destruction:
Exchange-traded funds are “weapons of mass destruction” that have
distorted stock prices and created the potential for a market selloff,
according to the managers of the FPA Capital Fund. “When the world decides that there is no need for fundamental
research and investors can just blindly purchase index funds and ETFs
without any regard to valuation, we say the time to be fearful is now,”
Arik Ahitov and Dennis Bryan, who run the $789 million fund, said in an
April 6 letter to investors in the actively managed fund. The flood of money into passive products is making stock prices
move in lockstep and creating markets increasingly divorced from
underlying fundamentals, the managers said. As the market moves ever
higher, there’s the potential for a sharp decline. The U.S. ETF market
has about $2.7 trillion in assets, the majority in products that track
indexes. ETFs have attracted more than $160 billion in new flows so far
this year, Bloomberg data show. Read more
On the research side, Wesley R. Gray is more conservative, he said:
We’ve heard a lot of questions recently from clients and readers regarding how ETFs might affect financial markets. The short answer is “nobody knows.” The long answer is researchers are trying to figure it all out. Read more
His post also includes brief summaries of recent academic research.
To conclude, both academic and practitioners communities are still
debating on the exact impacts of ETFs on the markets. However, we
started seeing a consensus: ETFs will increase volatilities and
correlations.
Position sizing and portfolio allocation have not received much
attention in the options trading community. In this post we are going to
apply a simple position sizing rule and see how it performs within the
context of volatility trading.
An option position can be sized by using, for example, a Markov Model
where the size of the position can be a function of the regime
transition probability [1]. While this is a research venue that we would
like to explore, we decided to start with a simpler approach. We chose
an algorithm that is intuitive enough for both quant and non-quant
portfolio managers and traders.
We utilize the market timing rule proposed by Faber [2] who applied
it to different asset classes in the context of portfolio allocation.
The rule is as follows
Buy when monthly price > 10M SMA (10 Month Simple Moving Average)
Sell and move to cash when monthly price < 10M SMA
This remarkably simple timing rule has been used successfully by
Faber and others. It has proved to significantly improve portfolios’
risk-adjusted returns [3].
Within the context of volatility trading, we compare 2 option strategies
1-NoTiming: Sell 1-Month at-the-money (ATM) put
option on every option expiration Friday. The option is held until
maturity, i.e. for a month. The position is kept delta neutral, i.e. it
is rehedged at the end of every day.
2-10M-SMA: Similar to the above except that Faber’s
timing rule is applied, i.e. we only sell an ATM put option if the
closing price of the underlying is greater than its 10M SMA. Note,
however, that unlike Faber, here we define the end of month as the
option expiration Friday, and not the calendar end of month.
A short discussion on the rationale for choosing a market timing rule
is in order here. Within the context of portfolio allocation, the 10M
SMA rule is used for timing the direction of the market, i.e. the PnL
driver is mostly market beta. Our trade’s PnL driver is, on the other
hand, the dynamics of the implied/realized volatility spread. But as
shown in a previous post,
the IV/RV volatility dynamics correlates highly with the market
returns. Therefore, we thought that we could use a directional timing
strategy to size an options portfolio despite the fact that their PnL
drivers are different, at least theoretically.
We tested the 2 strategies on SPY options from February 2007 to
November 2016. Table below provides a summary of the trade statistics
(average PnLs, winning/losing trades and drawdowns are in dollar).
Strategy
NoTiming
10M-SMA
Number of Trades
115
81
Percent Winners
0.68
0.69
Average P&L
18.84
14.87
Largest losing trade
-269.79
-248.50
Largest winning trade
243.54
154.22
Profit Factor (W/L)
1.77
1.64
Worst drawdown
-633.24
-339.91
Graph below shows the equity curves of the 2 strategies
As it is observed from the Table and the Graph, except for the worst
drawdown, we don’t see much of an improvement when the 10M-SMA timing
rule is applied. Although the 10M-SMA strategy avoided the worst period
of the Global Financial Crisis, overall it made less money than the
NoTiming strategy.
The non-improvement of Faber’s rule in the context of volatility
selling probably relates to the fact that we are using a directional
timing algorithm to size a trade whose PnL driver is the volatility
dynamics . A position sizing algorithm based directly on the volatility
dynamics would have a better chance of success. We are currently
extending our research in this direction; any comment, feedback is
welcome.
Reference:
[1] C. Donninger, Timing the Tail-Risk-Protection of the SPY with VIX-Futures by a Hidden Markov Model. The Wool-Milk-Sow Strategy. April 2017, http://www.godotfinance.com/pdf/TailRiskProtectionHMM.pdf
[2] M. Faber, A Quantitative Approach to Tactical Asset Allocation, Journal of Investing , 16, 69-79, 2007
[3] See for example A. Clare, J. Seaton, P. Smith and S. Thomas, The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation, Aug 2012, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2126478
More and more investors are using the power of computing
technologies and quantitative techniques to manage their portfolios
these days. They believe that quantitative trading can help reduce the
PnL volatility resulted from emotional decision making and thus increase
the consistency of returns. However, sometimes the machine beats the
man, and sometimes it does not. Recently, quantitative funds seemed to
suffer considerable losses after British Prime Minister Theresa May
shocked markets by calling a snap election.
Among the most high-profile losers was Connecticut-based
investment firm AQR Capital Management’s $13.3 billion computer-driven
Managed Futures Strategy, which lost 1.1 percent on Tuesday, according
to an investor who was told by the hedge fund, representing a loss of
more than $130 million. The same strategy made 5.2 percent on the day
the results of Britain’s EU referendum were revealed in June. Two other hedge funds run by machines, which the investor declined to name, lost 2.8 percent and 1.9 percent. Read more
As pointed out by Maiya Keidan et al, the strategies that lost money were mostly trend-following in nature.
Trend following is a very popular strategy. Another, lesser-known
type of quantitative trading, which we write extensively about in our blog,
takes place in the volatility space. Specifically, volatility traders
and hedgers bet on the future volatility dynamics or distribution of
returns. They can do so by using mathematical models to predict the
implied and/or realized volatilities. One of the most popular volatility
prediction methods is the GARCH
model. However, there exist other lesser-known quantitative methods,
such as factor model that can be used to predict the volatility and help
with decision making. As reported by Andrea Wong, such a factor model
is being used by a hedge fund.
VIX as of Apr 28, 2017. Source: Yahoo financeThere are a number of reasons to heed the signals from Noorani
and his team: their model, which analyzes around 30 macroeconomic
factors from rate differentials to China’s credit default swaps,
explains 91 percent of the movement in dollar-yen over a rolling
four-month period. It sent out warning signals in mid-February before
the dollar peaked. The framework was developed by Michael Hobson, a
professor of astrophysics at the University of Cambridge. Read more
While quantitative trading is believed to be beneficial to many
market participants, some observers and regulators are worried about its
negative impact on the market, especially during a downturn. Recently
Keith Savard wrote:
The risk of turmoil is even greater given that markets already
are trying to absorb a technological revolution that includes enhanced
algorithmic trading, the proliferation of electronic bond trading
platforms and increased reliance on exchange-traded funds (ETFs).Read more
So is the jury still out whether we should embrace quantitative trading or not?
Today Rupert Hargreaves wrote that in fact many Japanese insurers are following the same strategy
According to Bank of America’s findings, the investment plans
remain largely unchanged from last year. Domestic yields are too low for
buying Japanese Government Bonds, so life insurers are having to look
overseas to acquire the yield they require.
“Insurers plan to increase their overall holdings of foreign
bonds, much as they did in the previous term, but the weighting they
give to each geographic region will greatly depend on the US rate hike
environment, European political risk, and FX trends.”
However, the big change this time around is that these companies
are planning to buy foreign bonds ex-currency hedging, which may have
major implications for US corporate bonds. Read more
Not hedging requires that you have an accurate view of the market
directions. Even if you do, it’s still beneficial to hedge. For
example, with the expectation of rising interest rates, corporate
treasurers and Chief Financial Officers started thinking about how to
hedge the interest rate risks. Recently, Ajoy Bose-Mallick et al
presented a good article on fixed income hedging. They argued that
hedging is beneficial to both sellers and buyers:
Hedging the interest rate can protect both the lender and the
borrower as it brings certainty to the interest rate costs and hence the
available cash flows from the investment. This certainty means the
borrower has one thing less to worry about on their investment. Below we
highlight the key issues that should be considered
The authors also provided some examples of hedging strategies:
Type of hedge: Interest Rate Swap, Cap, and Collar are the main
hedging instruments. The choice of hedge instruments should be aligned
to the underlying business, and prevailing market conditions. An
Interest Rate Swap fixes the interest costs and has the advantage of
known costs, however it is not flexible if the loan is to be repaid
prematurely. Fixing the interest rate also has the disadvantage of high
opportunity cost in the case where interest rates remain low or become
even lower. The Cap is an insurance-like instrument and protects the
borrowers from interest rates going above a chosen level and lets
borrowers take advantage of prevailing lower rates in case rates do not
increase. The Cap can also be unwound at no further costs in case the
borrower decides to pay the loan prematurely. However, a premium is
required to be paid for a Cap hedge. The Collar hedge is a hybrid
between an Interest Rate Swap and a Cap hedge and fixes the interest
rate costs between chosen boundaries for zero or small up-front cost. No
complicated or exotic hedges, such as callable hedges, should be
considered and hedging notionals or tenors should not exceed the
underlying loan notionals or tenor. Read more
Another, simpler, hedging technique that uses Forward Rate Agreement is presented by Sunil K Parameswaran:
Uncertainty regarding future rates of interest is a matter of
concern to both potential borrowers as well as lenders. The former would
be worried about the spectre of rising rates, while the latter would be
concerned with the possibility of a rate decline. Consequently, both
kinds of traders may wish to hedge the risk regarding future rates of
interest. One such hedging tool is a forward rate agreement (FRA).
By using such a derivative one can lock in a rate of interest for
a transaction scheduled for a future date. Forward rate agreements are
cash settled. That is, on a specified future date the profit for one
party, or equivalently, the loss for the other party would be computed. Read more
No matter what hedging strategy, simple or complex, we are using, we
should have a good understanding of the hedging instruments, market
environments, various regulatory and operational requirements.
One of the examples was Mitsui Life, a Japanese insurer who bought
foreign bonds and then proceeded to hedge the currency risks. However,
as Tomo Uetake reported yesterday, another Japanese insurer thinks that
FX hedging is too expensive and decided not to hedge:
Japan’s biggest private life insurer Nippon Life Insurance Co
[NPNLI.UL] plans to boost foreign bond holdings without currency hedging
in an effort to counter low domestic interest rates, senior company
officials said on Wednesday.
Japanese insurers have been shifting into foreign assets in
search of higher yields, but the biggest challenge has been how to
secure sufficient returns after hedging against currency swings. “When appropriate, we plan to buy foreign bonds without currency
hedging this fiscal year (to March 2018), as we expect the dollar to
strengthen gradually,” Naoki Akiyama, general manager for Nipon Life’s
investment planning, told reporters. Read more
On the other hand, as pointed out by Adriana Barrera et al., Mexican
state-owned oil company Pemex still thinks that hedging to ensure price
stability is important:
Mexican state-owned oil company Pemex will consider repeating a
recently instituted hedging program in future years, as it looks to firm
up its balance sheet and avoid the need for surprise budget cuts, a top
executive said late on Tuesday.
Petroleos Mexicanos [PEMX.UL], as the company is officially
known, reported on Tuesday that it has hedged its output through
December, the first time it has done so in 11 years, as an insurance
policy against volatile oil prices.
The oil hedging program, which will run from May to December and
guarantees a price of $42 per barrel for up to 409,000 barrels per day,
will cost the company $133.5 million. Read more
Yesterday, Tom Lee pointed out some diverging signs in the stock market:
First, Lee is concerned that the long-term yield curve has
narrowed substantially. A flattening yield curve is a widely viewed
marker of slowing economic growth, as this suggests the expected return
of long-term spending then has smaller expected return on investment.
The spread between the 30-year Treasury yields and the 10-year Treasury
yields, as Lee observed, has flattened since just after the U.S.
election in November “and historically signals market weakness ahead.”
“In the past, the bond market has been much better at ferreting
out problems and smelling slowdowns; that’s the message from the yield
curve. So I think the bond market is really taking the position that
growth is going to disappoint, and the gap between the hard data and the
soft data is still pretty big,” Lee said Monday.
10 year Treasury June future. Source: Interactivebrokers
Next, he outlined that the credit spreads of high-yield debts started widening
Specifically, Lee notes that since 1998, the market has seen 30
instances in which high-yield spreads widened 60 basis points, as it did
in late March, and the market saw a decline in 93 percent of instances
(falling by a median 4 percent). The thinking is that high-yield
indicates a tightening of financial conditions. Read more
On the same topic, Sid Verma reported on Bloomberg that there are disparities between the stock and bond markets.
In the green corner are stocks. The Standard & Poor’s 500
index is just 0.2 percent away from a record high reached in March on
bets that Donald Trump’s administration will push through tax-code
changes to spark growth. In the red corner sit U.S. government bonds,
where benchmark 10-year Treasury yields have unwound almost half of
their post-election increase, suggesting a far more pessimistic view the
economy.
“The increasing divergence between global equity market
performance and bond markets has raised questions as to whom is right,”
Jefferies Group LLC analysts led by Sean Darby wrote in a note. Read more
How long will these divergences last and what would be the final outcome?
This is the question that everybody wants an answer.
This week, Rebecca Ungarino of CNBC pointed out that the problem is
not only in the loan defaults, but also in the decline of used-car
prices:
Used-car prices are sliding, and some warn that this trend could
have sharply negative effects on both relevant stocks and on the economy
as a whole. “This is a credit bubble in autos that is very reminiscent of the
subprime mortgage crisis,” Larry McDonald, head of global macro
strategy at ACG Analytics, said Friday in an interview on CNBC’s
And the decline in the used-car prices is already reflected in the credit default swaps of auto rental companies
Avis stock price. Source: Finviz.com Bets on the failure of Hertz and Avis to repay their bonds, as
measured by five-year credit default swaps, are on the rise as used-car
prices fall and auto loan delinquencies edge higher. Elsewhere in the
industry, automakers General Motors and Fiat Chrysler this month
reported March sales figures that missed expectations; Read more
However, some experts argued that the market capitalization of the
auto industry is too small to have a significant impact on the economy.
We will see what happens next. In the meantime, and as always, risk
management is key.
Two weeks ago, in a post entitled To Hedge or Not to Hedge,
we argued that it’s always important for corporations to hedge the
commodity prices and not to speculate. This post continues with more
examples that highlight the importance of economic hedging.
As oil price fluctuates, airlines can see their revenue vary widely.
They can reduce the revenue volatility by hedging the fuel costs
Globally, risk managers quote Southwest Airlines’ long running
(25 years) and successful corporate hedging programme, which makes up
one-third of their costs. Ryan Air remains one of the latest examples of
having hedged their exposures to the extent of 95% in 2017, having
declared price certainty as their target than low prices. Singapore
Airlines Ltd, remains another south-east Asian airline that has
currently reported to have extended its hedging horizon from the
previous 2-5 years hedging an average of 37% of its total fuel cost.
Meanwhile, Malaysian Airlines has taken a prudent approach in the
current oil price environment and has aggressively hedged 65% of their
fuel oil requirements for 2017 at about a bit north of $60/bbl. While
hedging is catching up as a healthy practice to protect the bottom lines
among airline firms globally it is yet to catch up in World’s ninth
largest civil aviation market—India, where the cost of fuel for an
airline fluctuates widely from 28% to 63% of its total operating
expense. Read more
Recently, the French election has caused some uncertainties in the
market as it was reflected in the term structure of volatility. As
reported by Laura Dew, some portfolio managers did not leave it to
chance and hedged their portfolios:
The latest hedge against potential turmoil in Europe employed by
TwentyFour is via an option position on a weaker euro versus the US
dollar. With the euro/dollar back up close to $1.08, rather than $1.05
where it has recently been, even a more market friendly French election
outcome may not cost money if the US dollar finds some of its prior
inertia. There is no such thing as a free option, but we think this is a
cheap way of protecting some downside exposure to an event that may not
be as clear cut as the polls suggest. Read more
As the results of increasing political risks in Europe, the corporate
credit spreads started widening. Japanese investors took this
opportunity to buy European bonds as an alternative to low-yielding
domestic bonds. However, they have to hedge the currency risks, as
pointed out by Hideyuki Sano:
Because they do not like exposure to foreign exchange
fluctuations, they use currency hedging on a large part of their foreign
bond investment. The hedging costs are closely tied to short-term interest rate
gaps between currencies and rises in dollar interest rates mean hedging
will become costlier for Japanese investors. On the other hand, because the euro zone’s short-term interest
rates are deep into negative territory, hedging for the euro costs
almost nothing, or sometimes even produces extra returns. Read more
The above examples provided insights into large corporation hedging programs and clearly demonstrated the importance of hedging.
This week, Rupert Hargreaves of Valuewalk pointed out that the
defaults in the auto sector started to spread out to other areas of the
market:
“Will rising consumer default rates spread from autos to other
loans? Yes. We are already seeing evidence that subprime personal
unsecured and credit card delinquency rates are rising from low levels
in recent vintages, and bank loan officer surveys validate this thesis.
Further, poor performance in auto loans is increasingly emerging not
only in subprime but also non-prime (and some prime) loans.” Read more
Likewise, on the corporate credit market side, Bob Stokes recently
wrote that European credit spreads are widening, meaning that investors
have become more fearful:
Many European bond investors are not so confident about the future. Yield spreads between investment grade bonds and lower quality
debt has been widening. This means investors in the shakier debt
perceive a greater risk of defaults, so they’re demanding a higher yield
for assuming that risk.
The bond market is behaving much as it did before previous credit
crises in 2008, 2010 and 2012. … On February 7, French 10-year notes
sank to an 18-month low, sending French spreads over German debt (top
chart) to their widest level since early 2014. Dutch and Italian spreads
(middle and lower chart) have likewise widened, recently touching
respective three-year highs. Read more
However, despite these warning signs, the equity volatility still remains relatively low. In fact, Nicholas Spiro wrote
The ability of markets to climb a “wall of worry” and turn a
blind eye to the plethora of vulnerabilities facing the global economy –
from the rapid build-up of corporate debt in China to the dangers in
exiting ultra-loose monetary policies, particularly in Europe and Japan –
seems to know no bounds. This makes it nigh impossible for economists
and investment strategists to predict with any degree of certainty the
catalysts and precise timing of the next major financial crisis
He also pointed out a reason for the subdued volatility
International investors – initially speculative ones such as
hedge funds, but more recently long-term institutional investors – have
been placing big bets on volatility remaining subdued for the
foreseeable future. These bets, known as “shorting”, or selling,
volatility in Wall Street parlance, have proven extremely profitable and
are suppressing volatility further.
Yet the more subdued the volatility, the greater the distortion
in asset prices and, once financial turmoil finally erupts, the bigger
the scope for a much more disorderly sell-off than would otherwise be
the case if investors had not been selling volatility over the past
several years.
What is clear is that the Vix has become a poor gauge of
investors’ sensitivity to the vulnerabilities and threats in the global
economy that could precipitate the next crisis. Read more
As of the close of today, the VIX index seems to be going down again.
With a decreasing VIX, investors might start thinking about selling
volatility. In fact, a post by Ellen Chang today discussed selling naked
puts. The post started with favoring put selling, but it then pointed
out some risks involved in shorting volatility:
While there is a limited upside, sellers of options should be
cautioned that there is a greater downside loss because you could lose
than more than 100% of your original capital invested. Writing options to generate higher returns comes with a large
amount of risk and “collecting an immediate payoff is not as easy as it
sounds Options writers are often compared to the house of a casino,” Ma
said. “It only makes sense if you have the large cashflow to pay out in
the short run. Remember, in the long run, the house always wins. Shorting the indexes is one strategy to profit from increased
volatility, but most investors are not comfortable doing because of the
increase in risk, said Meredith Zidek, a Hunt Valley, Md.-based options
and ETF trader. Read more
The chart below shows the VIX index from 2010 to the present.
As we can observe from the chart, the VIX has exhibited several sharp
spikes following relatively quiet periods. This means that selling
naked puts and not managing them correctly is indeed a risky business.
On the research side, a recent paper entitled Forecasting a Volatility Tsunami
by A. Thrasher presented several studies on the volatility spikes. It
also provides a method for predicting those spikes. Although we still
haven’t had any opinion yet on the merits of this prediction method, we
think the paper is worth a read
The empirical aim of this paper is motivated by the anecdotal
belief among the professional and non-professional investment community,
that a “low” reading in the CBOE Volatility Index (VIX) or large
decline alone are ample reasons to believe that volatility will spike in
the near future. While the Volatility Index can be a useful tool for
investors and traders, it is often misinterpreted and poorly used. This
paper will demonstrate that the dispersion of the Volatility Index acts
as a better predictor of its future VIX spikes.
