The Bull Market In Uncertainty

Includes: SPY, VXX, VXZ, XIV, ZIV
by: Elliott Orsillo, CFA

"There is a tide in the affairs of men, which taken at the flood, leads on to fortune." - Brutus, character from William Shakespeare's Julius Caesar

Last Thursday, we hosted an investment forum entitled The Certainty of Uncertainty, where we unpacked three sources of uncertainty and how to invest in the current environment. There is a bull market in uncertainty that is unsettling for many, but also creates opportunity for those willing to take the tide at the flood.

Artemis Capital Management is a leading hedge fund in the volatility space, or in other words, they are experts in being able to quantify uncertainty. In a recent research report, they posted the following chart, which maps out the probability of various 12 month returns for the S&P 500 (NYSEARCA:SPY) being priced into the options market.

There is a lot going on in this chart, so let's break it down a little bit. First off, the axis across the bottom labeled with percentages is plotting the implied 12-month gain or loss in the S&P 500. Pairing this with the vertical axis, which shows the cumulative probability of each implied outcome, lets us see which outcomes the market thinks is most likely. Lastly, we can see how these probabilities have changed over time with the date axis along the bottom. As the chart states, prior to the Lehman Brothers bankruptcy and corresponding huge sell-off in the market, tail risk, which we will define as a loss of 50% over the next 12 months, was relatively benign, with the options market only pricing in less than a 5% chance of such an event occurring. Post-2008, the story is quite different. There has been a "bull market in tail risk" with the probability of a 50% sell-off being priced at the 20%-30% range, which is depicted by the large spikes on the left tail of the graph reaching the light blue and orange range. In other words, post the 2008 market crash, investors are 4x-6x times more worried about another crash occurring than they were before the big sell-off.

This bull market in uncertainty is not unfounded (see here, here, & here), but it might be overpriced. If that is the case, then we want to find the best way to take advantage of the "flood" in uncertainty. One place where we see opportunity is the risk premium embedded in the VIX futures curve. For those that are unfamiliar with the VIX, it is an index that tracks the one-month implied volatility premium priced into S&P 500 options contracts. It is commonly referred to as the Fear Index, since it tends to spike and move upward when markets are selling off. The VIX index itself is not investable, but there are derivative products such as futures, options, and swaps, which are tied to the VIX. In addition, there are several popular exchange traded products (ETPs) that are tied to VIX futures.

VIX futures have expiration dates, at which point the price of the future will converge with the price of the VIX index. But because of the volatility of the index, VIX futures will rarely be priced the same as the VIX index prior to expiration. This is due to the "risk premium" being priced into VIX futures. This risk premium can be thought of as insurance cost. If someone wants to protect their portfolio from a market crash by purchasing exposure to the VIX (remember, the VIX typically moves in the opposite direction as the stock market), then the entity selling them that protection will demand a risk premium for the insurance. This is not unlike other types of insurance that people purchase on their cars, homes, and health.

The cost of insurance baked into the VIX futures curve can be measured by the difference in price between one futures contract and the next. For example, if the front month contract is trading at $15 and the second month contract is trading at $16, the $1 difference represents a 6.7% premium for the extra month of insurance. The embedded chart shows the average shape of the VIX futures curve under low (VIX 30) volatility regimes since the beginning of the "bull market in uncertainty." Under low volatility environments, the cost of insuring against a market sell-off is very high. The average cost has been 10% a month as measured by the difference in the 1st and 2nd month contracts.

In other words, an investor can (on average) make 10% a month by simply shorting the front of the VIX futures curve IF the VIX remains unchanged. This is a big if because the VIX is very volatile and rarely remains unchanged. A big spike upward in the VIX can quickly erase the profits from collecting the risk premium. A simple buy-and-hold approach to being short VIX futures would be considered "picking nickels up in front of a steam roller."

This is why we have spent the past 6 months developing a more nimble investment strategy, which we've coined VRT (Volatility Regime Trading). Without going into too much detail, VRT looks at three variables: the trend in implied volatility, the trend in realized volatility, and the shape of the VIX futures curve in order to determine which regimes are best for going short or long VIX related products (VXX, VXZ, XIV, and ZIV), or just sitting on the sidelines in cash. The backtested results, which have to be taken with a grain of salt, are very impressive, with a reward-to-risk or Sharpe ratio of 1.7 (e.g., 1.7 units of excess returns above the risk free rate for every 1 unit of volatility) compared with a 0.2 ratio for the S&P 500 over this same time period (12/31/05-1/31/13).

Investing in volatility is not for the faint of heart, and we size these positions accordingly for our clients within their allocation to Absolute Return strategies as part of our Diversification 2.0 portfolio construction. In today's markets, "…investors have never been more certain of their own uncertainty", to quote Artemis Capital Management. This bull market in uncertainty is providing excellent opportunities to compound above average, risk adjusted returns for those willing to take the tide at the flood.

Original Source: Taking the Tide at the Flood

Disclosure: I am long XIV, ZIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.

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