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Worth Every Penny

VIX: Reverting to the Mode

Three Myths of the U.S. Senior Loan Market

Building the Hope for Change

3 Reasons Putin's Nat Gas Deal Is A Big Deal

Worth Every Penny

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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This morning’s Wall Street Journal reports that “Investors are piling into the shares of small, risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns….”  We’ve commented on such risk-seeking behavior earlier, because it has an important bearing on the low volatility anomaly.

The tendency for low-volatility or low-beta portfolios to outperform market averages has been the subject of at least 40 years of academic and practitioner research.  Given its challenge to what “everyone knows” about risk and return, a number of explanations for the low vol anomaly have been advanced.

Our favorite, the so-called “preference for lotteries,” comes from the realm of behavioral finance.  The expected value of buying a lottery ticket is negative — so under the assumptions of classical economics, no one would ever buy a lottery ticket.  But this misses a broad swath of reality.  The behavioral explanation is that some people are willing to risk a known sum in exchange for the possibility, remote though it may be, of becoming humongously rich next Tuesday.

What’s the analog of a lottery ticket in the stock market?  The market’s lottery tickets are the shares of highly volatile, untested companies — exactly like the penny stocks cited by the Journal.  When investors pay up to buy volatility for volatility’s sake, it creates an opportunity for those who take the other side of their trades.  We see this in the results of our low volatility indices so far in 2014:

Low Volatility YTD 052214

It may appear paradoxical that low vol strategies are doing well when interest in speculative, penny-stock strategies is growing.  What behavioral finance tells us is that the two occurrences aren’t contradictory — in fact, one may be driving the other.

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

VIX: Reverting to the Mode

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Reid Steadman

Managing Director, Global Head of ESG

S&P Dow Jones Indices

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In the article at this link, Bill Luby – VIX analyst extraordinaire – dispels a misconception I have heard repeated at conferences and in presentations. Very often, people refer to VIX as “mean reverting.” This is not correct in the strictest sense of that phrase. VIX is not inclined to return to its long-term average. Rather, VIX is more likely to return to its “typical” levels. It’s more correct to say that VIX is mode reverting. I’ll explain more, since understanding this distinction is essential to understanding VIX. 

In Luby’s words, VIX has an asymmetric return profile. He notes that “VIX spikes are generally short-lived” and that “a low VIX often persists for extended periods.” 

Put another way, VIX is defined by its extremes. It’s like your hothead friend in high school who day to day is a reasonable guy, but occasionally, when something agitates him, he flares up and punches someone. Your friend’s average mood – halfway between calm and ready to commit criminal assault – doesn’t matter that much because he is rarely there. 

Let’s look at the past ten years, ending March 2014, to get a sense as to why an average is a less useful measure in the case of VIX. In that time, we have had 2,517 trading days. The average closing VIX value has been around 20. How many times has VIX closed at or around this average, say between 18 and 22 (those values inclusive)? The answer is 511 times, or 20% of all observations. 

Now let’s look at the most frequently observed level, the mode. After rounding, the VIX level that shows up most is 13. But how often does VIX land at or near this particular level? Again, let’s count. VIX has closed in a range between 11-15 exactly 955 times the past ten years, representing 38% of all trading days.

The best way to see this, however, is with a graph. You see huge upticks, particularly during the financial crisis. But VIX seems to drift back, sooner or later, to a certain base level.

Mode

So, the next time you are at a conference and you hear someone say VIX is mean reverting, boldly step up to the mic and correct them. You now know the real story.

 

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

Three Myths of the U.S. Senior Loan Market

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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The S&P/LSTA U.S. Leveraged Loan 100 Index has returned 1.76% year to date under performing vs. fixed rate high yield bonds.  The low rate environment and continued demand for yield generating asset classes has pushed the S&P U.S. Issued High Yield Corporate Bond Index returns to  4.32% year to date as yields have fallen by 38bps since year end.

Three myths of the U.S. senior loan market:

Myth 1: Senior loans are more volatile than high yield bonds:  the data just does not support this statement.

The five year standard deviation of index level changes (as of quarter end March 31, 2014):

  • S&P/LSTA U.S. Leveraged Loan 100 Index:  7.28%
  • S&P U.S. Issued High Yield Corporate Bond Index: 8.27%

Biggest index drop:

  • S&P/LSTA U.S. Leveraged Loan 100 Index:  -27.9% Dec 2008
  • S&P U.S. Issued High Yield Corporate Bond Index: -30.4% Nov 2008

(In Feb 2009, the S&P 500 was down over 46% and the S&P GSCI was down over 67%)

Myth 2: Interest rate floors built into many floating rate loans are a negative attribute of these loans: Senior loans are floating rate.  As rates rise, the interest rates these loans pay eventually rises.  Currently, approximately 80% of the loans in the S&P/LSTA U.S. Leveraged Loan 100 Index have interest rate floors that have protected buyers from the current extremely low rate environment.  As rates rise above those floors, the loans can be expected to pay even higher interest rates.  Meanwhile, lenders are getting higher rates due to these floors than had the floors not been in place. Prices of fixed rate bonds of course fall as bond yields rise.

Myth 3: The liquidity of the loan market is nonexistent:  During the first four months of 2014 over $198billion of senior loans have traded in the secondary market.  The 100 constituents of the S&P/LSTA U.S. Leveraged Loan 100 Index represented 25% of the trade volume (over $50billion). The Index is designed to track the most liquid of these senior loans and results in tracking over $237billion of loans by market value.LoantradevolumeApril2014

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

Building the Hope for Change

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Koel Ghosh

Head of South Asia

S&P Dow Jones Indices

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Last week India witnessed a historic event at the declaration of its 16th Lok Sabha election results. After a span of over 30 years has there been such a majority mandate handed out by the Indian voters who confirmed their need for change.

Equity Markets
The Indian equity market investors greeted the news favourably with the S&P BSE SENSEX crossing the 25000 mark for the first time in the history of Indian stock markets and further recorded as the third-best performer in Asia in dollar terms. To put it more plainly, the S&P BSE SENSEX has had a return of 15% in just the past 5 ½ months, since the start of this year.

Expectations
Eminent leaders of their field, reputed professionals, and renowned market experts have expressed their recommendation on the areas of reforms. Some of the key expectations are lower Inflation, strengthening of the rupee, improving overall growth rates, lowering of the unemployment rate, revival of the investment scenario and a common wish list among many, a boost to infrastructure.

Government Direction
The Government of India, Planning Commission in its Twelfth Five Year Plan (2012–2017) estimated the total investment in infrastructure sectors to be approximately one trillion dollars. The plan outlines new projects and development in airports with three new airports namely Navi Mumbai, Goa and Kannur. Additionally two ports in West Bengal and Andhra Pradesh. Development in railways to build out the Western and Eastern Freight Corridor, the Mumbai Elevated Rail Corridor and the High Speed Corridor. Roads also form an integral part of the developmental plan along with expansion in power and telecommunication.

Given the gamut of plan, funding of these infrastructure projects is critical. There is an expectation of a contribution of nearly 48% by the private sector. A funding gap is already projected in the plan and this is where the scope for inviting investments in this space broadens to provide the necessary boost.

Value Unlocking
Infrastructure can be the catalyst to provide the necessary boost to many sectors that can cumulatively contribute to economic and overall growth for the country. For those who want to avoid timing the markets or lack stock specific insights, index investing enables exposure to the sector and related returns via a rules based approach provided by an independent index provider.

While the euphoria of the elections is now settling down, May 26, 2014 brings in the swearing in of a new Prime Minister and a new government to realize the hope of a change … a change for a better India…” Acche Din Ayenge”( Good days are here to come)

 

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

3 Reasons Putin's Nat Gas Deal Is A Big Deal

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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It’s not just because it took 10 years to negotiate with China or is worth $400 billion, but the new deal Gazprom signed to supply 38 billion cubic meters (bcm), which is about the amount NY state uses annually, of natural gas to China each year for the next 30 years may be a major game changer for 3 big reasons.

The first big reason is that this deal may reduce air pollution in China.  That may not only clean the air for breathing but may reduce the erratic weather causing global warming that is spiking agriculture prices  and now possibly food prices.  Since the deal implicitly prices the natural gas China is receiving from Russia at a 25% to 40% discount to the cost of importing liquefied natural gas from overseas, this may not only cause China to use this gas over the rest of the world’s but it may motivate China to more actively replace oil and coal with natural gas as main energy sources. Given natural gas is cleaner, this in turn may reduce pollution. 

The second reason this deal is a big deal is that it may be the catalyst to building natural gas from a local commodity to a global commodity.  If natural gas becomes more standardized and tradable as a global commodity, it may not only reduce pollution by motivating the switch from oil and coal, but it may include specifications within the contracts to set forth guidelines to control pollution. Currently natural gas is the only commodity in the S&P GSCI where the World Production Quantity is determined based on regional (North American) production.  The globalization largely depends on the logistics and technology in order to transport the gas. For example, in 2013 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 the trick is having the infrastructure in place to execute the trade.  

Last, this deal may open investment opportunities across the energy spectrum. The construction of the pipeline may initially create some direct investment opportunities but as the pipelines start working, it may possibly further open futures markets, at least regionally if not globally, to encourage more production that may grow the entire market.

 

 

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