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Chris DeMuth Jr.
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"It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it - who look and sift the world for a misplaced bet - that they can occasionally find one." - Charlie Munger I look... More
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  • How Much Would You Pay To Avoid Volatility? 20 comments
    Dec 17, 2012 11:27 AM | about stocks: VXX, TVIX

    Other than expected value, what factors impact your investing decisions?

    It appears that one common answer since the financial crisis has been a strong, pavlovian dread associated with volatility. I ask this question because we always start by asking what investment counterparties want - or want to avoid - for reasons other than expected value. Who are the non-economic actors and what are they doing? Over the past few years, the answer appears to be "dreading volatility".

    Volatility, in and of itself, is neutral to expected value but investors appear to be utterly price-insensitive in attempting to avoid it. With the emergence of faddish financial innovation in the form of various exchange traded notes, it is convenient for investors, including low information retail investors, to express this preference in the capital markets.

    Over the past year, this trade has represented an almost perfect transfer from volatility avoiders to expected value seekers. Perhaps the most infamous example is the iPath S&P 500 VIX Short Term Futures ETN (VXX). This security has an expected value of $0.00 over time (and can be directly shorted via either the equity or indirectly via equity derivatives) but serves the purpose of near-term volatility avoiders in the interim. It allows both sets of investors to achieve their stated aim. Over the past year, it is down by over 84%; it will probably achieve similar results in the future.

    Does VXX represent the worst idea / best short ever? Almost, but not quite. It is true that with VXX, you can lose much of your invested capital over time. However, if you are in more of a hurry, VelocityShares Daily 2x VIX Short Term ETN (TVIX) represents a way to lose your invested capital at once. Over the past year, it is down by over 98%; while the arithmetic becomes tricky, it will probably manage to achieve similar results in the future too. In fact, this one is such a disaster ( / beauty to short if any when borrow is available), that the sponsors sort of disowned it in March 2012, at which point, it began trading unhinged from its underlying market and built up a massive premium before that premium collapsed. Buyer beware. Or better yet, buyer run for the hills. Best still, short them to zero. When they delist, collapse completely, or simply disappear in a cloud of recriminations and litigation, we'll happily be in the tax-advantaged situation of never having to cover.

    What are the lessons that I am trying to learn from this experience? For me, the key lesson is that anything - anything - that is added to a mandate dilutes from other goals and in this case price-insensitive volatility hedging comes at a price. When a lot of people appear to be saying "get me out of here (at any price)!", they will probably make superb counterparties. If you will allow me a moment of sentimentality during the holidays, let me say that there are more important things in life than money. However, there are not more important things in investing than money. Find someone who disagrees, take the other side of their proposition, and you'll both get what you came for. As for me and mine, we'll take the money.

    Update as of 8/2/2013

    (click to enlarge)

    Disclosure: I am short TVIX, VXX.

    Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

    Themes: Volatility, expected value Stocks: VXX, TVIX
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Comments (20)
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  • Yes, TVIX and other long volatility products are probably the worst "investment" products ever foisted off on ill informed retail investors. The most important question is why are they even allowed to exist or be listed on exchanges. It is precisely these types of securities that are destroying investor confidence in capital markets.
    16 Dec 2012, 02:12 PM Reply Like
  • Untrusting, I think you are exaggerating a little when you say "It is precisely these types of securities that are destroying investor confidence."


    I doubt that more than 1% of all retail investors have ever purchased (or sold) a volatility ETN. I have no data, but the number is probably closer to one in one thousand investors. Such relatively unknown products hardly "destroy investor confidence" in general.


    They may be horrible products, but that's not the point I'm arguing.
    17 Dec 2012, 09:59 AM Reply Like
  • When you look at financial product innovation a bit more broadly, there are a significant number of retail investors getting a rotten deal. Leveraged ETFs across the board all erode their value, not just the volatility products. TVIX just happens to be the worst of the worst.
    18 Dec 2012, 01:18 PM Reply Like
  • Author’s reply » Thanks for the comment; I agree 100%. In fact, we shorted and, when available, used equity derivatives to further express a negative view on, leveraged inverse ETFs for oil, gas, gas equities, gold, silver, and equities while also shorting a leveraged ETF for China and the long bond. Some of our favorite investment ideas have included this theme. For 2011, we shorted ZSL as described here: For 2012, we shorted TMF as described here:
    18 Dec 2012, 01:47 PM Reply Like
  • Chris, I just discovered you and am really enjoying your articles and comments.


    I agree 100% on this topic, but what is the point in publishing on this opportunity? Seems better to lay low and keep printing money for ourselves.
    10 Jan 2013, 10:36 AM Reply Like
  • Author’s reply » Thanks for the great question. What initially most surprises me about the history of investing is that investing for value has not destroyed itself. Sure, specific opportunities get gobbled up. But, when I read the first few Buffett Partnership letters about workouts, my reaction was, “well, that ends that!” but such types of opportunities keep arising. I think that there are enduring +EV opportunities that survive both widespread information and judgment required to exploit them.


    For example, the VXX and TVIX have dramatically exploitable characteristics for a short to collect a positive expectancy, but what first led me to the topic of volatility itself were utterly price-insensitive investors who laid out their dread of volatility. Over the past four or five years, people, real live adult people free on their own recognizance, told me that they were more sensitive to volatility than expectancy such that I could transact with them and we would both get what we wanted: they would get to avoid the appearance of short-term volatility and I would get their money.


    My conclusion is that such non-economic actors are driven by agency problems, embedded games, and narrow mandates. My job in exploiting the situation was to first take on as few of those characteristics as possible and then secondly to provide liquidity when it was demanded. I would be the price-sensitive, time-insensitive side and they would be the price-insensitive, time-sensitive side of these markets. They are not trying to purchase bargains and this is simply a matter of their being really really bad at it. They are trying to do something else. In many cases, they are simply trying to do – and keep – their jobs and such jobs have a lot of arbitrary incentive structures. For evidence, I routinely poll various conventional money managers to ask what percentage of their efforts are due to expectancy and what percentage are due to exogenous factors such as career protection, committee dynamics, rigid hierarchies, and institutional mandates. Most answers range within the mid to high single digits of expected value. I only do the expected value part of investing.
    10 Jan 2013, 12:06 PM Reply Like
  • Nicely written. @Chris I like the way you frame this as an exchange of expectancy vs. volatility. That's not a totally ridiculous proposition as it's the basis for an enormous insurance industry where you take a negative expectancy in return for reduced volatility.


    Of course, there's well priced insurance and ripoff insurance. I'd say this is more like "trip cancellation insurance" or Best Buy's extended warranties. Clearly negative expectancy, and not protecting against financial ruin like auto liability or health insurance does.


    Maybe these products have really created a marketplace exchange for expected return vs. risk. I know which end I'll be on
    10 May 2013, 02:28 PM Reply Like
  • Author’s reply » Me, too!
    10 May 2013, 02:42 PM Reply Like
  • If you haven't read it you should read this paper:
    Also check out Figure 8 and note the drawdown being short VXX (the price increased 4x on the product) going into the global financial crisis.


    I don't agree with their trading rule when it is long because I find the long positions on these too risky but the short rules seem reasonable and it's worth reading. Also of course ^VIX is mean reverting so it's statistically safer to do these bets with high ^VIX...
    10 Jul 2013, 12:28 PM Reply Like
  • Author’s reply » Thank you very much for the link; I look forward to reading the paper.
    10 Jul 2013, 12:35 PM Reply Like
  • NP. The exact trading rules may be overfitting but I think the underlying idea of harvesting the volatility premium is a good one, and discussed in more quantitative detail from what you mentioned here.


    And what do you think of EBIX? ;-). My thoughts are I don't know how to handicap potential fraud issues so I just stay away from it. Too many sharks attacking the same company...
    10 Jul 2013, 12:45 PM Reply Like
  • Author’s reply » I am not long or short. However, I find the short thesis compelling. Liars lie. And the EBIX CEO is a liar.
    10 Jul 2013, 01:52 PM Reply Like
  • That makes sense. As more of the allegations of misconduct / fraud came to light I exited some long positions I previously had. Luckily the price was so volatile that I was able to exit with a profit. Being a novice investor I don't have any deep understanding of fraud so I was basically just playing a counting game where I counted the number of major issues with the company. e.g. BP was "1 major issue (deepwater drilling issue)" so I felt fine taking a long at one point; for Ebix the number constantly increased to now "4 major issues" (MSFT lawsuit, attorney general probe, SEC investigation, troubling issues surrounding the CEO such as misstatement of his charity donations and shareholders getting a bad deal in the take-private). For a long position I try to determine the probability of fraud from this counting and if it gets more than about 5-10% I can't justify the position (since I am no expert in fraud I would only feel confident taking bets at very low and very high probabilities of fraud).
    10 Jul 2013, 02:24 PM Reply Like
  • Please correct me if I am wrong, but according to modern financial theory, volatility IS risk, as in beta, NOT lower expected value. I have never understood that view, but basically your counterparties include the products of the most prestigious business schools. It bothers the hell out of me, how could all these smart guys make such a stupid mistake... I will not have peace of mind until I at least understand where they are coming from.
    23 Aug 2013, 10:27 AM Reply Like
  • Author’s reply » Correct, according to modern financial theory, volatility is risk. This view is a thinking proxy, a way to use a formula to avoid fundamental security analysis. It is embedded rationality, in which the people who hold the view make out fine (their investors not so well).
    23 Aug 2013, 10:42 AM Reply Like
  • Sort of. At least for the periods researchers data-mined high beta tends to underperform what the CAPM predicts and low beta tends to outperform [1]. So behavioral finance says statistically that beta may be risky, but less risky than people think.


    All active investing is futile unless you have an edge of say 4%+ over indexing per year, since after taxes and transaction costs you'll just match the index (which historically returned around 6% after inflation). People have been successful with all sorts of edges, including market making, quant, value, growth, etc. The problem with the CAPM crowd is that first, value investing contradicts it, and value investing has been an inspiration for various edges for 100 years, and second, the economic equilibrium models academics have built, like Chris points out, haven't done so well, e.g. Merton and Scholes at LTCM, or Andrew Lo's mutual funds [2].


    My guess is that these models are (a) overfitting, (b) the academics tend to be very famous for their works by the time they are put into use, so they aren't "private information", and (c) the academics tend to not be in the same economic boat as their investors so they are more prone to risk taking.


    23 Aug 2013, 11:17 AM Reply Like
  • Author’s reply » True and well said/written.
    23 Aug 2013, 11:21 AM Reply Like
  • byslkwd -- A good analogy might be the gun control debate. The academics would argue guns are risky in general, and high beta stocks are risky in general. That's because they use statistical models, and statistically, these are true statements -- many value stocks are falling knives, so "high beta is risky" is indeed a true statement over the universe of all stocks.


    Likewise guns are statistically dangerous. However, if you've handled a gun and are a careful person you will realize it's only dangerous depending on how you use it. Analogously, given correct analysis of a particular company, any "risk" from beta is greatly reduced (perhaps to zero if the downside on the investment failing is zero).


    The key point is different investment philosophies can all co-exist and make their skilled adherents' money (except of course CAPM, whose adherents just blow up their investments). However, even practitioners in the top quartile of skill will lose money relative to the index due to taxes and transaction costs. Thus one has to be very careful and diligent when doing any investment, and make sure that any return rates are sufficiently above the index on an after-tax basis.
    23 Aug 2013, 10:36 PM Reply Like
  • Author’s reply » Good discussion and points all around.
    24 Aug 2013, 07:10 AM Reply Like
  • Love that statistical answer to explain the academics- best I ever heard, and allows us to understand both viewpoints!
    27 Aug 2013, 10:22 AM Reply Like
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