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Uncorrelate Me

Uncorrelate Me

There's a lot of money being thrown into the alternative investment space nowadays. You see the trend reflected in the market capitalizations of exchange-traded products designed to offer returns uncorrelated or negatively correlated to the equity market. From 40,000 feet, the AI landscape looks like a crazy patchwork of diverse strategies. Oddly, two of the five largest ETPs have produced the worst

There's a lot of money being thrown into the alternative investment space nowadays. You see the trend reflected in the market capitalizations of exchange-traded products designed to offer returns uncorrelated or negatively correlated to the equity market.

From 40,000 feet, the AI landscape looks like a crazy patchwork of diverse strategies. Oddly, two of the five largest ETPs have produced the worst performance records. To understand why these products remain popular, you have to zoom in for a closer look.

While we're at it, we might as well look at the rest of the tier to see what makes these AI heavy hitters so attractive.

iPath S&P 500 VIX Short-Term Futures
ETN (NYSE Arca: VXX, $1.275 billion AUM)

iPath S&P 500 VIX Medium-Term Futures
ETN (NYSE Arca: VXZ, $765 million AUM)

Yearly Fee 0.89%

Inception: 29 January 2009

In 2004, the CBOE Futures Exchange introduced S&P 500 VIX Futures based upon the option market's widely followed “fear index,” the CBOE Volatility Index, or VIX. The spot VIX is derived from the real-time prices of options on the S&P 500 Index and reflects investors' consensus view of future (30-day) stock market volatility.

The “fear” in the “fear index” refers to the volatility assumption embedded in the options' premiums. Market volatility tends to increase dramatically in downdrafts; bull moves, on the other hand, are associated with diminishing volatility. Option sellers build in their expectations of market volatility when they price their contracts. All other things held equal, option premiums tend to inflate when volatility is expected to increase; options tend to cheapen when there's a volatility downturn anticipated.

The iPath notes seek to replicate the total returns earned by holding a long position in VIX futures. The VXX note tracks the return from daily rolls of first- to second-month VIX futures, resulting in a constant one-month maturity.

The VXZ note measures the return from rolling long positions in the fourth-, fifth-, sixth-, and seventh-month contracts, yielding a constant five-month maturity. The distinction between the VXX and VXZ maturities is significant, as we'll soon see.

No matter what maturity is employed, volatility futures provide a hedging mechanism for equity investors. A long volatility position in futures, or the ETNs that track them, can negate the downside “tail risk” associated with holding stocks.

Keep in mind that word “can.”

The spot VIX is a proxy for 30-day volatility assumptions, but VIX futures — and the ETNs following them — represent forward expectations for VIX. Trading VIX futures is, in essence, a wager on the 30-day implied volatility in the contract's delivery month. That said, an appreciation of the shape of the VIX futures curve — that is, the degree of its “contango” or “backwardation” — is critical.

In a low volatility environment, the VIX futures curve tends to exhibit contango. Contango describes a pricing phenomenon in which nearby contracts trade at a discount to later deliveries. A volatility contango persists now, as depicted in Table 1.

For cash-settled VIX contracts, the contango reflects expectations of higher market volatility in future months.

The upward slope in the futures curve also spells L-O-S-S for traders who hold long-term VIX hedge positions. If you buy a VIX futures contract and roll it forward, you'll lose money since you must sell the expiring and lower-priced contract to finance the purchase of the higher-priced deferred delivery. As you can see from Table 1, this effect is most deleterious if you make short-term rolls at the front-end of the curve such as those mimicked by the VXX note's index. Rolling from the first to second delivery, for example, costs two volatility points (200 basis points); a roll from the fourth to the seventh month — the type proxied by the VXZ note — costs just 180 basis points, the equivalent of 60 basis points a month.

Still, a loss is a loss. Both VXX and VXZ have sunk deeply under water since their 2009 launch. VXX has lost nearly 41 percent a year while VXZ has been trimmed by 23 percent annually. The contemporaneous annual gain in the investable S&P 500 Index — the SPDR Depository Receipts (NYSE Arca: SPY) — averaged 32 percent. From this, you might surmise VXX and VXZ to be negatively correlated to the blue chip benchmark. And you'd be right. But that, obviously, hasn't made the ETNs good portfolio additions. As stand-alone investments, or as long-term hedges, the ETNs' portfolio stats, depicted in Table 2, are rather dismal.

With such lousy returns, you've got to wonder why the VXX and VXZ notes are so popular. There are two reasons. First of all, savvy investors and traders use the ETNs tactically as short-term hedges against anticipated volatility spikes rather than as long-term portfolio diversifiers. That makes for a rather volatile chunk of the ETNs' market capitalizations as hedges are laid on and lifted.

More common, though, are spreads of VXX against VXZ that are designed to capture the decay at the short end of the VIX forward curve. A short VXX/long VXZ trade has been a real alpha snagger for institutional portfolios and sophisticated traders. Begun with equal dollar weights, the spread has produced an average annual gain in excess of 9 percent since 2009. Now, that may not seem very attractive, given the 31 percent return obtained by the SPY portfolio, until you consider the spread's standard deviation. The volatility of daily spread returns, at 6 percent per annum, is a third of SPY's, making the spread a much more reliable source of gains. Chart 1 depicts the spread's trajectory versus SPY while Table 3 spells out the compelling nature of the trade — excess annual returns of 7 percent against a beta-adjusted SPY investment. That's why the notes get so much traffic.

PowerShares DB G-10 Currency Harvest (NYSE Arca: DBV, $372.1 million AUM)

Management Fee: 0.75%

Estimated Futures Brokerage Expense: 0.06%

Total Expense: 0.81%

Inception: 18 September 2006

The DBV portfolio is an index tracker that attempts to mimic a currency carry trade. In a carry trade, investors borrow capital at low interest rates and use the loan proceeds to purchase higher yielding assets elsewhere.

DBV's underlying benchmark shifts exposure among the world's top 10 developed country currencies — the G-10 — via futures. The objective is exploitation of the trend in which high-interest-rate currencies rise relative to low-interest-rate currencies.

At any given time, the DBV portfolio “finances” its long positions in the three highest-yielding G-10 currencies with short positions in the three lowest-yielding currencies. The G-10 universe includes the U.S. dollar, the euro, the Japanese yen, the Canadian dollar, the Swiss franc, the British pound, the Australian dollar, the New Zealand dollar, the Norwegian krone and the Swedish krona.

In DBV's last rebalance, the highest yields were earned by the Aussie and Kiwi dollars and the Norwegian krone. Scraping the bottom of the yield barrel were the Swiss franc, the yen and the U.S. greenback. Each currency now represents a third of the portfolio — the long positions positive, the short positions negative.

Currencies are generally thought to exhibit low correlation to equity returns. That may be true at certain times; DBV has shown a definitive direct relationship to large-cap stock returns since its 2008 debut, as illustrated in Chart 2.

DBV and SPY have essentially broken even since the currency fund was launched. DBV has produced an average annual return just south of zero while SPY's return is barely positive, ergo the negative alpha seen in Table 4. However, for a long period of DBV's life — January 2008 through December 2010 — the portfolio outperformed SPY. Contributing to this was DBV's relatively low volatility. The standard deviation of DBV's returns is a third lower than SPY's. The potential for outperformance, together with dampened volatility, accounts for DBV's popularity.

IndexIQ Hedge Multi-Strategy Tracker (NYSE Arca: QAI, $137.1 million AUM)

Management Fee: 0.75%

Expense Pass-Through: 0.38%

Total Expense: 1.13%

Inception: 25 March 2009

The QAI portfolio seeks to replicate the performance of a multi-strategy hedge fund index, but isn't comprised of hedge funds at all. Instead, QAI owns other exchange-traded funds, relying upon a proprietary, quantitative methodology that screens the ETF universe for liquidity and correlation to the returns of certain hedge fund strategies (long/short equity, global macro, market neutral, event-driven, emerging markets, and fixed income arbitrage). The index portfolio is then constructed by combining the sub-indexes representing each of the six hedge fund strategies.

Thus, QAI is an exchange-traded fund of funds attempting to replicate a hedge fund-of-funds strategy.

While hedge fund returns, by definition, are uncorrelated to those of the equity market, the QAI portfolio exhibits a fairly strong and direct relationship to the SPY fund. The fund-of-fund approach, however, dampens volatility significantly, making the correlation a little hard to see (Chart 3). QAI's average annual return was just shy of 5 percent since inception, compared to SPY's 29 percent, but the hedge fund proxy's volatility was just 40 percent of the blue chip portfolio's. The low volatility yields a very attractive Sharpe ratio despite an unremarkable alpha.

PowerShares S&P 500 Buy/Write Portfolio (NYSE Arca: PBP, $135.8 million AUM)

Management Fee: 0.75%

Inception: 20 December 2007

PBP tracks the CBOE S&P 500 Buy/Write Index, a benchmark designed to measure the return of a hypothetical buy/write, or covered call, strategy on the S&P 500 Index. The portfolio consists of a long index position overlaid with a succession of one-month, at- or slightly out-of-the-money index call sales.

Buy/writes provide investors with positive returns in up markets and can outperform naked long stock or index positions in flat or falling markets. It's essentially a neutral-to-slightly bullish strategy. In trade, covered call writers give up the unlimited profit potential of their assets in strong bullish moves. The net outcome of a buy/write program ought to be a return profile that's smoother than that of outright long positions.

Until recently, it looked as though PBP's returns would realize that objective. Volatility, however, began a collapse in late 2010, putting the squeeze on call premiums. That, coupled with the rising equity market, crimped returns. Since inception, PBP's compound annual loss has been more than 4 percent, 2 percent worse than the contemporaneous loss earned by the SPY portfolio. Chart 4 and Table 6 tell the tale.

Wrapping it up

There's as much variance in the returns earned by alternative investment strategies as there is in more conventional asset classes. Among the most heavily capitalized exchange-traded product-based strategies, two stand out for their delivery of positive since-inception returns — the IndexIQ Hedge Multi-Strategy Tracker and a spread between the iPath S&P 500 VIX Short-Term Futures ETN and its sibling, the iPath S&P 500 VIX Medium-Term Futures ETN.

No single strategy can be counted on to produce positive returns in all market conditions, of course. A diminution in volatility expectations, for example, could radically change the shape of the VIX futures curve and squeeze spread returns.

For now, though, this is where the big money's landed in the AI space. Capital flows toward opportunity and, at times, safety. A year from now, our roster may be topped by five different ETPs.

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