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View from Down Under

Passive Risk Management

Lower Gas Bill? Why Not?

Turn VIX into information you can use

Right Beta equals Right Alpha

View from Down Under

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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The world view in Sydney is quite different than in New York.  No one is worried or disgusted with the US government’s recent shutdown or debt ceiling follies – in fact only a few even comment about it. Likewise much of the anxiety American analysts suffer about the unemployment rate, weak GDP growth and “policy uncertainty” is completely absent. A glance at some of the figures can explain some of the differences. When the Great Recession rolled through the US and Europe, little happened in Australia. At the worst moment real GDP was up, not down, by one percent from 2008 to 2009; the unemployment rate is less than the US, and inflation is comparable to the US.   The stock market is up about 15% year to date, a bit behind the 22% for the S&P 500.  Maybe this is a reminder to Americans to spend less time worrying about the ineffectual US government.

All this shouldn’t suggest that down under no one ever thinks about the US. The newly nominated Fed chair is a topic of interest.  As in America, people forget that the last three Fed chairman (Volcker, Greenspan and Bernanke) all demonstrated that the Fed can and will act when necessary.  Questions hint that Janet Yellin could find little room for maneuver or be a lame duck from the start – not likely to happen.  No one knows more about how the Fed work and how to make work than Janet Yellin.  The other topic of interest is Obamacare – lots of questions and skepticism crops up in the news media.

China is a topic of interest all over, including in Australia.  Unlike the US worries about a future world power, here the question is whether China’s growth and its appetite for Australia’s natural resources will fade.  Recent numbers suggest there is not too much to worry about.

In any event, it is back to the US and the old worries next week.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Passive Risk Management

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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In major cities at this time of year, an army of street vendors bristling with umbrellas await their chance to emerge in entrepreneurial fervour, providing tourists and commuters alike with immediate respite from unanticipated rain. It’s a viable business strategy: the chaotic nature of weather means that occasional rainfall remains practically impossible to predict*, hence our common tendency to rely on an adaptive strategy. Demand and cost rises with tempestuous environments, while the inconvenience of preparing for the worst is a frustrating drag in sunnier times.

 So does the same strategy of purchasing protection “as needed” work in the stock market? And does it cost more to do so? Stretching the analogy somewhat, we’ll look at three simple strategies to mitigate equity risk, and explain a little more behind the three indices shown below, each of which incorporates a different way to hedge an investment in the S&P 500® Index dynamically:

Passive RM 1

Source: S&P Dow Jones Indices. Total returns shown for the five year period to October 18th, 2013. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results.

1)      Move to sunnier climates: permanently avoid more risky stocks

The “low volatility effect,” sometimes called the low volatility “anomaly,” refers to the tendency – manifest across a wide range of markets – for stocks with low volatility to outperform their peers, especially in terms of risk-adjusted returns. While academics continue debate the underlying dynamics – a behavioural explanation supposes that speculatively minded investors will gladly overpay for a potentially oversized return** – investors can capture this effect through indices that underweight or remove stocks with higher volatility. The S&P 500 Low Volatility Index removes 80% of the most volatile stocks from the index and weights to the remainder inversely proportional to their historical volatility.

2)      Go back inside when it’s wet: exploit regimes in volatility

Volatility tends to persist: the level of the volatility today can be a guide to volatility tomorrow. If markets are currently choppy, it therefore may make sense to de-risk going forward. Systematic “risk control” indices realize this approach by explicitly targeting a prespecified risk level, dynamically allocating between equity and cash (in more volatile periods) in order to maintain the target. As well as potentially providing better performance, indices with such controls have gained widespread traction because of the reduced costs of protection – significantly cheaper put options in particular.

3)      If everyone else is preparing for a storm, maybe you should too

The so-called “fear index”, VIX, reflects market expectations of future volatility. Surprisingly (perhaps), a high level of actual volatility shows a mild historical bias towards a subsequent positive return for VIX futures. Additionally, the VIX has also historically shown trending behaviour (if people are getting more worried, maybe you should too). Taken together, this suggests that a high and increasing VIX is a potentially useful signal.

Strategies that aim to capture trends or regimes typically show performance somewhat idiosyncratic to the specifics of their individual signal construction, but with nearly four years of live history the S&P VEQTOR Index provides a concrete example of the latter concept, using levels and trends in volatility to allocate between the 500® and short-term VIX futures.

Passive RM 2

Over the past five years, each of the three risk management strategies above resulted in an improved risk/return profile in comparison to the S&P 500®. And while we are duly assured that history is no guide to future performance, such results certainly support the view that dynamic risk management may be sensibly obtained without the costs of appointing an external active manager. Not dragging your golfing umbrella round in the sunshine, on the other hand, is likely to remain beyond the aegis of science. At least the street vendors will be glad of that.


* Even the much-admired UK Met Office only targets 70% accuracy for predictions over the next three hours.

** Anyone unconvinced might consider the (financially irrational) demand for lottery tickets.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Lower Gas Bill? Why Not?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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As mentioned in my last post, logistics and technology are the two key factors in propelling commodities from local markets to global markets. The U.S. is now expected to be the biggest producer of natural gas in 2013, so what does that mean for the residents? Will gas bills be cheaper? Will there be a growth of U.S. natural gas into a global commodity?

The U.S. Energy Information Administration (EIA) showed the following graph in a recent report:

US Gas Producer 2013

Although the U.S. natural gas production is set to surpass Russia and Saudi Arabia, natural gas is one of the most difficult and expensive commodities to store and transport. Below is a map that shows the production across the U.S. where the Northeast has had tremendous growth.

US Gas Map

From these 10 major locations, the challenge is to store and transport the gas. One way to see this through indexing is to look at the negative roll yield by subtracting the price return index from the excess return version. Notice two things in the chart below are that there has not been a significant positive roll yield since Feb 2003 and that there is a recurring high seasonal cost around this time of year.

Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 20, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance
Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 21, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

Also notice how high on average the roll costs are in Sept-Oct versus the rest of the year and that Oct 2013 has the lowest Oct roll cost since 2005.

Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 20, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance
Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 21, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance

With that, the S&P GSCI Spot Index Level is down to 61.7 from a starting point of 100 on Dec 31, 2002.

Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 21, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance
Source: S&P Dow Jones Indices. Data from Dec 2002 to Oct 21, 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance

Which as a general measure of the market, falls in between the residential and wholesale prices shown below.

Nat Gas Res WS

Why do the wholesalers get the cheaper price but consumer like you and me have to pay? As Quoctrung Bui points out in his article, a big chunk of our gas bill is the cost of building and maintaining pipes. Just the mechanism that Gary Morsches discussed in his interview. Those costs don’t go down when natural gas prices fall, so the prices consumers pay for gas haven’t fallen nearly as much as the wholesale price for gas.

Last, the question of whether U.S. natural gas can grow into a global commodity might depend on where the heaviest investment is spent. Many companies that produce goods out of natural gas are eagerly building facilities to take advantage of low prices, but that will cut into inventory and eventually drive prices up again if production can’t keep up with demand.  Also, there are a few countries with larger natural gas reserves than in the U.S. –

Nat Gas Reserves

and if they invest more heavily in exploration and production – or technology as Gary puts it, than in logistics (China announced $13 billion in planned spending for E&P), then the chance U.S. natural gas becomes global is less likely.  Earlier in the year there was news of a U.K. company signing a deal to bring U.S. natural gas to U.K. homes, which may help the U.S. natural gas globalization, but then the real question may be how long it will last.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Turn VIX into information you can use

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Reid Steadman

Managing Director, Global Head of ESG

S&P Dow Jones Indices

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Most people think of VIX as simply an index.  This makes sense — the “I” in VIX stands for that very word.  But VIX is more useful than your average index.  It could easily be grouped with economic indicators, like the unemployment percentage or new home sales.  Why?  Because the VIX level — not just the changes in that level — contains valuable information.  In this post I will show you how, with some high school math, you can extract this information and arm yourself with knowledge that will inform your investment decisions.

VIX is not your typical index
When an index provider starts calculating a new index, they will choose a starting point, a base level.  This can be any number —  100, 1000, or even a million.  Investors correctly don’t pay much attention to that.  It’s the percentage changes in this index, driven by the increases and decreases in value of the securities it comprises, which are of most value to the market.

In the case of VIX, movements up and down are important as well.  However, the actual VIX level means something too.  It communicates the 30-day implied volatility of the S&P 500.  In a previous post, I explained what this means.

But how can we arrive at the 30-day implied volatility?  How do we convert the current VIX level into this information?  This isn’t hard, but it does require some simple math.  Here are the two steps.

  1. Turn the VIX level into a percentage.  So, a VIX level of 15 equates 15%.  This is the annualized implied 30-day volatility for the S&P 500.
  2. Deannualize VIX to turn it back into its true monthly measure.  The formula for this is to divide the VIX level, as a percentage, by the square root of 12, the number of months in a year.

This table shows how VIX levels translate into 30-day implied volatility figures using this approach.

 

You may wonder why we would divide by the square root of 12.  My advice is to put this deep question aside and to concentrate on the basics.  For now, it is sufficient to know that you can back out the 30-day implied volatility from the VIX level with this simple formula.

Understanding what “volatility” is in the context of VIX
The implied 30-day volatility of the S&P 500 tells you the likely range of possible index levels the market “expects” in a month.  If the implied 30-day volatility is 4.3% — which equates a VIX level of 15 — then this means that the market expects the index to have a return that is within a range that spans 4.3% higher and 4.3% lower than the index level.*

We say “expects” because the market isn’t sure and is instead communicating what will probably happen.  You will remember from your basic statistics courses that when someone brings up probability, a bell curve soon follows.  This blog post is no exception.

Below is a normal distribution, the most common type of probability distribution that supposes that most data points will fall near the average.  On this type of curve, one standard deviation comprises about 68% of likely outcomes.  In our case, the data points in the bell curve are possible index levels the S&P 500 could arrive at 30 days from now.  The 30-day implied “volatility” that VIX conveys is one standard deviation in the bell curve, which is centered on the index level.

 

Putting this knowledge into practice
Now that you know the basics, let’s use them.  Assume that today, the S&P 500 level is 1710 and the VIX level is 18.  What additional information can you extract from these two data points?

As a first step, turn the VIX level into the 30-day implied volatility:

Turn VIX into a percentage: VIX = 18 = 18%

Then deannualize it:  18% / √12 = 5.20%

Second, apply this percentage to the index level:

1710 x 5.20% ≈ 89

Third, subtract and add this amount to the index level to tell you the range the market expects the S&P 500 to trade in 30 days from now, with a 68% confidence level:

1710 + 89 = 1799

1710 – 89 =  1621

The range between these numbers, 1621 to 1799, is where the market expects the S&P 500 to trade in 30 days, with a reasonably high level of confidence.  You may agree or disagree with this, but this is what the market believes, and this is a powerful starting point around which to build an investment strategy.

* Using the current index level is a helpful shortcut.  In reality, the probability curve is centered around the forward price of the index, which is the current index level adjusted for various payments the investor hypothetically might have received or lost, including interest, dividends, and income from stock lending.  Making these adjustments matters less if you are only looking ahead a short time and if interest rates and dividends are low.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Right Beta equals Right Alpha

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Anubhav Srivastava

Head - Product Development

Motilal Oswal Asset Management

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In India, over the past few months, investors have seen their investments erode in value. All asset classes are highly correlated and a simple debt plus equity diversification does not help either with the returns or with lowering volatility. In this scenario, Index based investing as a part of larger asset allocation strategy is now beginning to gain ground among advisors and investment advisory platform alike.

Using index ETFs’ gives the advisors several advantages – the investment and holding is transparent, low cost and comes with the credibility of the Index owner / calculating agent. Furthermore, most indices come with built in RIC and UCITS compliance thereby ensuring optimal diversification within and reducing company specific risk.

In turbulent and for institutional investors looking at both temporary exposure as well as complex quantitative strategies, index investing is both more efficient from a risk perspective as well as significantly cheaper.

In India, with the advent of foreign index based investment avenues, Private Bankers as well as Independent Financial advisors have shown a keen interest in indices. These allocations form a part of return enhancement as well as risk mitigation strategies for bespoke portfolios.

Some challenges do remain and these are primarily regulatory. Currently Insurance companies and pension funds have significant restrictions placed on them for index exposures. However, these are expected to be resolved in the near future.

S&P Dow Jones Indices is an independent third party provider of investable indices.  We do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties. The views and opinions of any third party contributor are his/her own and may not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.

The posts on this blog are opinions, not advice. Please read our Disclaimers.