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Ananthan Thangavel
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Ananthan Thangavel is the Managing Director of Lakshmi Capital and Lead Writer for the RealFinance Commodity Analyst Newsletter. He is particularly proud of producing a return 35.01% annualized since inception (through 12/31/11) for his Lakshmi Capital Global Macro ARS clients... More
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  • Mutual Funds: Value Added or Value Destroyed?
     A friend recently approached me because her employer was discontinuing one of its pension plans, and she wanted to know how her investments had performed and what she should do with her money.  I had no intentions of pitching her, but the more I described the pitfalls of mutual funds to her, we inadvertently discussed why the style we employ at Lakshmi, separate accounts, is more amenable to most investors’ goals.  A separate accounts strategy entails each client having their own account, owned by the client and managed by the investment advisor.

    While professional investors understand the limitations of mutual fund investing, most individuals do not understand the nuances that make them, in my opinion, subpar investment vehicles.

    Let’s first review the pros of mutual funds:

    1)      Exposure to stocks and bonds

    2)      Allocation and specific investments selected by professionals

    The advantages of mutual funds mainly stem from the professional management of client’s funds.  Client assets are pooled into one large fund, and the manager allocates the assets to the stocks and bonds he sees fit.  However, the perceived advantage of pooling client funds actually hampers performance of these funds in the long run.

    Cons of mutual funds:

    1)      Large size limits investment choices
    Since mutual funds, especially the ones allowed by corporate pension plans, tend to be very large, the stocks and bonds they are able to invest in are very limited.  For example, consider a $10 billion mutual fund.  If the fund manager wishes to take positions in 20 stocks, he must deploy $500 million in each stock.  For regulatory, liquidity, and control reasons, mutual funds do not want to own more than 10% of any one company.  This means that each company must have a market capitalization of $5 billion or greater.  Obviously there are a huge number of companies out there with great growth potential that have less than $5 billion in market capitalization.  This makes sense because all large companies were at one point in time small companies.  However, because of mutual funds’ size limitations, investors are completely cut off from these opportunities.

    2)      Lack of agility or mobility in investments
    Since mutual funds are heavily regulated investment pools, they may only take positions in stocks and bonds.  This means that mutual funds are completely disallowed from owning currencies, commodities, futures, and options, which comprise a huge portion of global investment activity.  Furthermore, while mutual funds technically have the ability to short stocks, only about 10% of mutual funds have this ability, and fewer than 2% ever actually exercise it.  This means that mutual funds depend on rising stock and bond prices for their performance.  Given the volatile times as of late, this is a dangerous dependence at best and pure folly at worst.

    3)      The relative performance game: incentive for managers to maintain mediocre performance
    Mutual fund managers’ worst nightmare is to underperform the S&P 500 Index, or whatever index they claim to be their benchmark.  This is because underperformance of the index is a sure-fire way to lose clients, and eventually, one’s job.  To guard against this, mutual fund managers prefer to own the stocks in the index they want to be tracked against.  This is because if they own the stocks in the index, they may not outperform it, but they will certainly not underperform it.  If they choose to take a large position in a stock not in the index, they have the chance of outperforming the index but also of significantly underperforming it.  Basically, the risk/reward ratio for them is not worth the chance of losing their job and stature in the industry, so almost all managers take the safe approach, which is to replicate the performance of the stock indices as closely as possible.
    However, not only is underperformance of the indices a large problem in the mutual fund industry, it is actually inevitable.  Since mutual fund managers may only take long positions in stocks and bonds, they depend on a rising stock market for positive performance.  Most stocks tend to move together, so the performance of a large mutual fund will almost never be more than a few percentage points different than the major stock indices.  Add to that the incentive that managers have to not underperform the index, and it is easy to see why very few mutual fund managers ever beat the index, especially after adjusting for fees.

    4)      Mutual fund fees can be exorbitant
    A disturbing trend we have observed recently is the compounding of mutual fund fees.  In such a manner, clients are placed in mutual funds with exotic and seemingly goal-focused names.  One such fund is the “Vanguard Target Retirement 2045 Fund.”  To the average person, this would seem like a good idea, a fund that is constructed so as to target your eventual retirement in 2045.  But why does this matter at all?  Is the manager going to try to make more or less money based on your exact target year of retirement?
    This fund displays one of the oldest and dirtiest tricks in the mutual fund business, which is a mutual fund whose only holdings are other mutual funds.  The fees charged on the 2045 Fund are .2%, a seemingly cost-efficient structure.  However, the only holdings of the 2045 Fund are four other Vanguard mutual funds, and each of these funds charges their own fees as well!  This type of fee compounding is endemic across the mutual fund industry.
    While basic index mutual funds can avoid such problems, the more exotic the fund, the larger the fees they charge.  Chances are that a pan-Asia, ex-Japan mutual fund will charge in excess of 3% annually, and may even charge an upfront load, meaning a percentage of your funds being deposited will take a haircut right off the bat.  If you consider that this fund probably has no shot of beating the index it is tracking, there is very little reason to pay such high fees.

    In summation, the only real benefit of mutual funds is their ability to expose the investor to asset classes like stocks and bonds.  However, with the advent of ETFs, mutual funds are obsolete for this purpose.  ETFs are essentially electronic mutual funds that track indices and replicate their performance very closely, but with no human manager calling the shots.  Because they have no human workforce managing the day-to-day operations, ETFs also charge far lower fees than mutual funds and have historically had closer tracking to the indices.  For a passive investor who simply wants exposure to equity and fixed-income markets, ETFs are a superior choice than mutual funds.

    However, it is our firm belief that Lakshmi Capital’s strategy, separate accounts, provides the best of all worlds.  Utilizing a separate accounts strategy, Lakshmi clients can have their portfolios tailored to their individual risk preferences, liquidity needs, income necessities, and all other investment criteria.  Furthermore, Lakshmi trades futures, stocks, bonds, commodities, and options for its clients, both on the long and short side.  Lakshmi can also invest in any size company it wishes, depending on the size of the client’s portfolio, in order to take advantage of growth opportunities in small and mid-capitalization companies.

    We believe that separate accounts put the interests of advisors and clients in alignment, and provide clients with the best opportunities for profitable investment.  As investors grow wary of mutual fund giants who add little to no value, it is our hope that investors consider separate accounts at Lakshmi Capital a more attractive solution.



    Disclosure: Long ETFs
    Tags: Mutual Funds
    Oct 20 1:49 PM | Link | Comment!
  • Time to Short the January VIX Futures
     We have commented in the past on our preference to short volatility and express long positions on stocks by selling put options.  We executed this strategy with great success during the pullbacks of June and August.  However, there remains a potentially extremely profitable trade within the short volatility space.

    Shown below is a chart of the January VIX futures contract.

     

    As of today, the January VIX futures contract is trading at 30.15, down 15 cents on the day.  Take note that this contract is trading down -.5% on a day when it’s underlying index is trading up +4.1%.  Why is this the case?

    The VIX is a mean-reverting index, meaning its’ protracted moves in either direction are likely to revert to their base at some point.  The fundamental reason for this is that the VIX measures the amount investors are willing to pay for insurance (specifically the implied volatility of the S&P 500 option contracts, with a heavy skew towards put options).  During times of great uncertainty or panic such as 9/11, the financial crisis, or the “flash crash” earlier this year, investors greatly increase the amount they are willing to pay to insure their stock portfolios.  However, as time passes and the psychological shock of the event dissipates, the VIX tends to drift downwards again as sellers of these insurance contracts are willing to accept less and less until the index reaches a level near to where it traded before the event.

    As a result of this mean-reverting behavior, the relationship between options and futures on the VIX does not behave as it does for any other commodity, currency or stock.  VIX futures and options almost always trade at a heavy discount or premium to the underlying VIX index.

    Currently, the VIX index is at 22.60.  At this level, the January VIX contract represents a 33.4% premium to the underlying VIX index.  This means that traders’ expectations for volatility in the future are tremendously higher than our current level.  While this can be taken as an ominous sign, it is worth noting that VIX futures for 3-6 months out have traded at heavy premiums to the VIX index ever since the rally starting in March 2009 began.  Simply put, there are many more buyers of volatility than there are sellers.

    Our recommendation is to short the January VIX futures contract.  We believe that the current dislocation represents an enormous opportunity.  In order to turn a loss by selling a January VIX futures contract, the VIX index must by 33.4% higher upon expiration on January 18, 2011.  To illustrate the unlikelihood of that event, we have prepared the following chart of the VIX index over the past 10 years.

    As can be seen from the chart, the 30 level on the VIX index has only been achieved and sustained rarely over the course of the past 10 years.  During the 2000-2002 bear market, the VIX index flirted with this level before skyrocketing above it after 9/11.  Between 2002-2003 the index was also above 30 for much of the remainder of the bear market, which witnessed aggressive selling of equities before bottoming in late 2002.  Between 2007-2009, the VIX witnessed an incredible spike due to the financial crisis.  The most recent spike above 30 occurred in May 2010, directly after the “flash crash” incident.

    After each one of these shocks, the VIX witnessed a precipitous fall, mainly due to the mean-reversion nature of the index.  As we believe the summer correction was only a pullback in the context of a broader bull market, the January VIX futures are grossly overpriced.  In order for the VIX index to be above 30 upon expiration, a significant exogenous shock to the stock market would be necessary, and even if this shock is witnessed, it would need to be timed almost exactly at expiration due to the likelihood of the index falling as quickly as it rose.  Even if one believes that our current pullback is the beginning of a bear market, the magnitude of the decline in equities would need to be quite violent in order to sustain a level above 30 on the VIX.



    Disclosure: Short VIX January Futures
    Tags: VIXX, VXZ
    Sep 27 1:31 PM | Link | 4 Comments
  • Time to Short Volatility? Note: Published May 21, 2010
    Recent action in the markets is obviously very scary, and I am certainly among the most scared.  But I wanted to delve into the internals of the option market to see how what we're going through right now compares to the last 10-12 years or so of market action, and I found some interesting observations.


     
    I shared the VIX Rate of Change chart a couple weeks ago after the flash crash, and it has become even more pronounced.  The VIX explosion of the past couple weeks has now equaled the explosion seen during Lehmann/AIG collapse during 2008.  This is striking, as we have not seen nearly the same drop in equity markets as was experienced during the 2008 run-up in the VIX (-35% drop on the S&P in 2008 vs. a 13.64% drop in the last couple weeks).




    While the rate of change on the vix measures the volatility of volatility index, which can be a dubious feature to understand, if you boil down what is being measured, it can be put to use more effectively.  Since the VIX is calculated using the prices of out of the money put and call options on the S&P 500, with a heavy skew towards puts, the VIX is measuring the price paid for put options.  When the VIX skyrockets, it is indicating that the amount that investors/speculators are willing to pay for put options has skyrocketed.  So simply speaking, the last time investors increased the amount they were willing to pay for options increased this quickly was the reference period in 2008 when the S&P fell 35%.  Since the market has currently fallen only 13.6% from the April 26 peak to yesterday, it seems the option market has priced in a full on economic collapse much more quickly than the equity markets have indicated such a likelihood.



     
    Possible reasons for such a discrepancy range from the obvious to the not so obvious: people are obviously very afraid, and since many equity investors made such a large amount since the March 2009 low, it makes sense that many of them are rushing to buy puts to protect gains.  However, in viewing the total amount of put options traded on a daily basis going back 3 years, and weekly basis going back 12 years provides more insight.



    The daily amount of put options traded in the last 2 weeks has twice exceeded the all-time high set back in 2008.  The weekly chart shows that this last week was the most put options ever traded in the US.  To me, this indicates massive speculative put buying is also responsible for the explosion in the VIX.



     
    If you're looking to trade this market, above is a Put/Call chart from the last 10 years.  The red dotted line is the 5 day moving average of the CBOE Equity Put/Call Ratio.  This ratio measures how many put options are traded versus call options on a daily basis.  This ratio is commonly used as a contrarian indicator, showing that when investors are most fearful and buying the most puts, the market is actually primed to rally.  The 5 day moving average of the put/call ratio has exceeded 1.00 only 4 times in the past 10 years.  Of these 4 times, the S&P has experienced rallies of an average of 17.89%, lasting a shade over 2 months each time.  This contrarian strategy produced these results with zero drawdown 3 out of 4 times, and the 1 occurrence that did experience a drawdown initially was only 5% before rebounding to a total of +14.6% including the drawdown period.  However, it is certainly worth nothing that each of these rallies occurred during an ongoing bear market, and catching the intraday lows to fully capture these gains is very difficult, but if you can buy equities during this time period and get out after a ~10% gain, it seems like a relatively safe trade.


    Disclosure: Short SPX puts, Short NDX puts, Long ES futures
    Tags: SPY, VIXX, VIX
    Sep 27 1:32 AM | Link | Comment!
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