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A Simple Hedge Strategy

Money Grows on THESE Trees

View from Down Under

Passive Risk Management

Lower Gas Bill? Why Not?

A Simple Hedge Strategy

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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Alternative investments for high net worth investors are like the weather — everyone talks about it, but no one does anything about it.  In fairness, alternative investments — hedge funds, private equity, and the like — are often hard to access and complicated to explain.  But if they can deliver on their promise of uncorrelated returns — i.e., can serve as an effective hedge to an investor’s equity portfolio — then the game may well be worth the candle.

Not all alternative strategies are complicated or inaccessible.  The S&P Dynamic VEQTOR Index, e.g., exploits the well-known inverse correlation between the equity market and volatility.  When volatility spikes, in other words, the equity market typically plunges, whereas when volatility is declining, equities typically do well.  So an index which is long both volatility and equities has the potential to deliver a relatively smooth pattern of returns compared to either asset class in isolation.  That, it a nutshell, is what VEQTOR aims to do.

And successfully so, as the graph below demonstrates.  We’ve graphed trailing 252-day (i.e. approximately one year) returns for both the S&P 500 and the S&P Dynamic VEQTOR Index.  When the equity market was at its worst (e.g. during the 2008 financial crisis), VEQTOR did extremely well, since that’s exactly when its long volatility position was paying off.  During more normal equity environments, VEQTOR tends to lag.

VEQTOR vs S&P 500

One of the remarkable things about VEQTOR is that it’s relatively uncommon for it to show a loss on a trailing 252-day basis.  (Notice how the red line in the graph is typically above zero.)  We can measure this effect by asking how often VEQTOR lost money:

VEQTOR Probability of Loss

The chart tells us that, of all the 252-day lookback periods in our data, the S&P 500 lost more than 20% 12.7% of the time.  VEQTOR never lost that much.  The other rows have an analogous interpretation.  Most notably, VEQTOR lost money only 11.2% of the time — substantially less than the S&P 500.

This pattern of returns — limited downside with negative correlation to the equity market — is exactly the pattern of returns that makes alternatives appealing .  VEQTOR demonstrates that such patterns can be both attractive and accessible.

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

Money Grows on THESE Trees

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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My parents used to tell me that money doesn’t grow on trees, but they didn’t know about the Eucalyptus trees in Australia like the one shown below.

Money Tree

The science journal, Nature Communications, reported Eucalyptus trees in western and southern Australia absorb gold through their roots and transport it up all the way through their leaves.  The findings suggested the trees could tap into gold deposits up to 115 feet deep. While the amount of gold found is relatively small, these trees may help miners more efficiently locate gold deposits, which over vast lands, may otherwise be a costly process.

Over the past decade, as gold prices rose, gold companies spent heavily on new capital projects and exploration as shown in the chart below.

Gold Production Cost

However, that level of spending may not be sustainable since the price of gold has fallen 28.6% from its peak price on August 22, 2011, as measured by the S&P GSCI Gold.   

 

Source: S&P Dow Jones Indices. Data from Jan 1978 to Oct 24, 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 Jan 1978 to Oct 24, 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.

Cutting capital costs may not be the best solution though, since that may result in a decline in production, and consequently drive up the cost of producing each ounce of gold. The Citi report containing the above production cost chart also showed that despite the tenfold rise in capex over the past 12 years, production fell 5%, with unit costs rising 16% annually.

While it is possible the Eucalyptus trees could help reduce capital expenditures, gold prices continue to be more strongly influenced by the quantitative easing.  Yesterday on Oct 24, 2013, S&P GSCI Gold reached a new high of 786.2, since Sept 19 when the Fed announced it would not taper its bond buying.  If the U.S. economic data keeps missing expectations, then the dollar may weaken and the Fed may continue its stimulus, supporting gold even further.

 

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

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.