Indexology^® Blog

Recently, we have seen quite a bit of discussion on the S&P VEQTOR Indices. Most of the discussion focuses on its use of VIX futures, complicated allocation process, short back test history, and performance drag. This post is meant to to clarify a couple of the unique characteristics of this index.

Initially it is worth noting that the purpose of this index is to simulate an allocation algorithm that has low correlation with the equity market and provides efficient hedge in black swan events. This is main reason why for a majority of the time, VEQTOR allocates 10% to VIX and generally has a performance drag. The index is not supposed to be an alternative to the S&P 500. I think of it as similar to why I pay for health insurance and adjust my insurance plan every year according to my expectation of next year’s health care expense. As a young professional, more often than not I would have saved money if I simply went uninsured. However, this extra expenditure makes me sleep better. And that’s exactly why some market participants choose to allocate a portion of their assets to VEQTOR, despite its performance drag.

While it is true that VIX spot and futures are related, it is also true that they are quite different. But VIX future’s hedging property is undeniable, especially in black swan events. In a strong bear market, the VIX futures curve tends to flip from contango to backwardation, and the roll process tend to generate extra yield.  Refer to the following two papers for a discussion of VIX spot and futures: “Identifying the Differences Between VIX Spot and Futures” and “Access to Volatility Via Listed Futures.”

VEQTOR acknowledges the roll cost of the VIX futures and attempts to dynamically adjust its allocation between VIX and equity by monitoring market signals. Complicated at the first glace, its allocation process actually only uses two quantitative signals: realized volatility and implied volatility trend. They essentially tell you what has happened and what could happen in the market. The cutoff points (10%, 20%, 35% and 45%) of the realized volatility are driven by the long term performance of the S&P 500. Since the index is designed to address equity market tail risk, we picked the numbers close to the 20^th-, 80^th-, 95^th– and 98^th-percentile of monthly realized volatility. To establish the trend of implied volatility, we compared VIX weekly average with its monthly average. A week is roughly 5 trading days (Happy Memorial Day! We work one day less this week!), and a month is roughly 20 trading days. And VEQTOR monitors them for 2 weeks to determine whether the trend is substantial. Why 5? Why 20, not 21 or 22? Why 10? Honestly, a slight change in those numbers (give or take one or two days) would not change the essence of the VEQTOR framework or significantly impact its allocation results.

If you are interested in VEQTOR allocation process, please refer to its methodology and our white paper, “Dynamically Hedging Equity Market Tail Risk Using VEQTOR” from May 2014.

On February 27, 2007…

The Dow dropped 416 points. Freddie Mac announced it would no longer buy subprime loans that have a “high likelihood” of borrowers not meeting monthly payments.

The VIX rose over 7 points that day. It’s been above 11.15 ever since.

Until about an hour ago.

Recently at a panel discussion that I participated, one topic we talked about was if the bond price volatility in Asia is an obstacle to the investors. I believe it is a common misconception in the market.

A volatility analysis was run on the local currency denominated bonds of the 10 countries that tracked by the S&P Pan Asia Bond Index, which are China, Hong Kong, India, Indonesia, Korea, Singapore, Malaysia, Philippines, Taiwan and Thailand. Excluding the relatively high volatilities in Indonesia and Philippines, most countries have an annualized volatility around the 2% level. Interesting to note, while Indonesia and Philippines bond markets are more volatile, they also have the strongest growth in size among the 10 countries, as they expanded more than fourfold and threefold since December 2006.

We also compared the five-year annualized volatilities of the S&P Pan Asia Bond Index (denominated in USD) with other major bond markets, such as the U.S. treasury, U.S. investment grade corporate, U.S. high yield corporate, Eurozone sovereign and Australian bond markets, see the exhibit below. It is observed that the bond price volatility in Asia (even accounting for foreign currency fluctuations) is not necessarily higher than the other major markets. In fact, the S&P Pan Asia Bond Index has been historically less volatile than the S&P U.S. Issued Investment Grade Bond Index for the periods of one-year, five-year and since December 2006.

Want to take a closer look at Pan Asian Fixed Income? Please continue to read http://www.spindices.com/documents/education/practice-essentials-closer-look-at-pan-asian-fixed-income.pdf

The S&P Pan Asia Bond Index is designed to provide a broad and independent benchmark for the local-currency denominated bond markets. Country-level and sector-level indices are available.

The announcement by the European Central Bank that it would charge negative interest rates to banks for their deposits at the central bank – effectively a fee for having the central bank hold the money – raises arguments for eliminating paper currency and going digital.  The pros and cons were summarized in the Financial Times and in some blogs.

Digital money need not mean bitcoins – these suggestions are electronic currency maintained by the central bank.  One would trade the greenbacks in your pocket for the credit and debit cards you already have or an app on your phone. For many people there would be little difference.

There would be one advantage for the Fed: if the economy was weak and they wanted you to spend your money, they could encourage banks to charge negative interest (a fee) for keeping money in the bank.  You could pay the interest fee, spend your money or invest it.  You couldn’t take the cash and keep it in your  bottom bureau draw.  While this might be efficient monetary policy, most of us wouldn’t like it.  Lest this sound completely impossible, it was tried with little result in Denmark recently.  It’s not much different than a checking account where you pay service fees for writing checks.

Leaving aside monetary policy, eliminating cash would have other effects.  No one knows how much tax evasion and other illegal activity depends on using cash, but most believe the number is substantial.  About three-quarters of the total value of US currency is in $100 bills. Stated differently, there are about 30 one hundred dollar bills in existence for each person in the US – that’s $3000 in cash. Most people don’t carry that much lunch money. One offsetting factor is a lot of that circulates outside the US.  Eliminating paper currency would curtail some illegal activity by making anonymous or secret transactions more difficult.

Lest this look like a bonanza for the government, they would pay as well.  Currently the government benefits from the seigniorage from money creation.  It doesn’t cost $100 to print a hundred dollar bill, so the government “earns” the difference between the printing cost and the face value of the currency.

Despite some apparent arguments for eliminating cash, it doesn’t seem very likely in the near future, if for no other reason that it would be unpopular and difficult to accomplish.

On May 27^th, 2014 an article appeared in the Wall Street Journal titled “New Costs From Health Law Snarl Union Contract Talks”. This article provides an interesting insight into the challenges both employers and Unions face under the Affordable Healthcare Act as they try to determine the future cost of health plans that have been in place for decades in many cases. Putting a specific financial value on the cost of a health plan for a period of 3 to 5 years, particularly a known plan covering a known group, should be a relatively routine task. However, under our current insurance/ASO structures, there is no way to lock in such a cost over a multi-year period. Either the employer is at risk if actual costs exceed the projections, or the union must accept a very high risk charge to cover the worst case cost of the health plan. Regardless of how the issue is resolved, the situation is a lose-lose environment for both parties.

This is a situation for which the S&P Healthcare Claims Indices can be utilized. With the introduction of the S&P Healthcare Claims Indices both employers and labor now have a common measure of the average market rate of healthcare cost changes (trend) for any time period. By utilizing the indices, the two parties can now take advantage of several options to structure solutions to resolve the problem. Consider a couple of relatively simple examples:

• The employer and union could agree that the contract will use the index as a neutral measure of market cost changes. By comparing the plan’s financial trend to the market’s trend (in essence “marking to market”) both the employer and the union have a shared goal of improving the plan’s financial results. If the plan’s actual trend was lower than the S&P trend for the same period (meaning that the plan’s financial performance was better than the market average measured by the index) then the plan would have a surplus which could be used to reduce future contributions from the union employees. Likewise, if the plan’s actual trend was higher than the index, then the employee contributions might be increased to cover the shortfall. Under this approach, both parties have an incentive to manage the cost of the health plans as carefully as possible – an incentive that typically does not exist currently.
• An employer could use the S&P Healthcare Claims Indices as the basis to negotiate a financial contract with a third party, such as an insurance carrier, reinsurer or bank, that limits the employer’s liability for healthcare costs in excess of a set trend over the period of union contract. In effect, the employer has entered into a futures contract for healthcare costs. The contract would function as a hedge, in much the same manner as a futures contract is used to hedge commodity costs, or investment performance. The result is that both the employer and the union could determine the cost of health care benefits under the union contract with a high level of confidence. Both the union and the employer would understand the value of the healthcare program – and they could then decide whether to make changes to the plan provisions in order to change that cost.

Futures contracts are a well understood mechanism and have demonstrated their value across any number of markets. Is their utilization as to hedge against future health care costs just the next step in this financial structure’s evolution? The index linked approach would also work much the same way as reinsurance or catastrophic insurance in other insurance markets, with the indices being used as the final settlement value to the cost guarantee.