Indexology^® Blog

The Dow Jones Sukuk Total Return Index (Ex- Reinvestment) delivered a total return of 6.37% in 2014, which outperformed its 0.23% gain in the prior year; see Exhibit 1 for the index performance.

Exhibit 1: Total Return Performance of the Dow Jones Sukuk Total Return Index (Ex-Reinvestment)

With the continued growth in the sukuk market, the total market value tracked by the index rose 32% to USD 48 billion, as of December 31, 2014.  Comparing the new issues in 2013 and 2014, both the count and the size grew; the average sukuk deal size reached 880k, see Exhibit 2 for the comparison.

Exhibit 2: New Issues Comparison

Source: S&P Dow Jones Indices. Data as of December 31, 2014.  Charts are provided for illustrative purposes.

Looking at the new issues in 2014, the biggest sukuk issuer was IDB Trust, totaling 3 billion, followed by Saudi Electric, totaling 2.5 billion.  There were new entrants in the sovereign sukuk space, such as South Africa (issued 500mio) and Hong Kong (issued 1 billion), and the returning issuer Indonesia (issued 1.5 billion).

Since last fall, the S&P 500 has gone through three distinct downdrafts.  Between September 18 and October 15, the index fell by 7.3%.   It recovered that lost ground, and then some, rising

11.8% through December 5.  Then a second, less severe, decline began, as the index fell 4.9% between December 5 and December 16, followed by a 6.0% recovery through December 29.  This brought the S&P 500 to its (so far!) all-time high.  From December 29 through yesterday’s close, the index is down an additional 3.7%.  Patterns in the S&P MidCap 400 and S&P SmallCap 600 Indices have been very similar to those in the 500.

The net of these gyrations is a total return of 0.6% in the 82 days since September 18, but with heightened volatility; the standard deviation of daily returns for the S&P 500 was 14.5%.  In the 82 days prior to September 18, the standard deviation of daily returns was only 8.0%.  So we have just come through a period that is relatively directionless but quite choppy; investors who are preoccupied by the chop may not even notice that their total returns are still positive.

One of the notable things about directionless, choppy markets is that defensive strategies tend to do surprisingly well.  The S&P 500 Low Volatility Index, e.g., rose by 8.7% since September 18 — mitigating the three periods of decline, while lagging the S&P 500 during its rebounds.  This pattern of protection in down markets and participation in up markets is typical of low volatility strategies, and seems to occur on a global basis.   The low volatility flavors of the S&P 400 and S&P 600 also provided protection in the recent down periods and participation in the up moves.  It’s not perfect protection, obviously, and it’s not full participation, but the record shows that all three low vol indices performed as we would have expected.

We’re dealing with only four months of data, of course, and past performance is never a guarantee of future results.  And it’s fair to say that low vol strategies have historically lagged in a strong market advance.  But for investors who want equity exposure, would prefer a smoother ride, and are willing to underperform in a strong market — low volatility strategies may offer a comfortable port in the storm.

While many assets have some relationship with oil, there are varying degrees of correlation and even a few surprises. For example, Canadian equities are more correlated with oil than are the emerging markets and the US equities; Australian equities are barely correlated with oil, and China who is not nearly as big a producer as a consumer is moderately correlated with oil.

Gold and (Brent) oil are not as oppositely related as many think but have a weak-moderately positive correlation of 0.32. (Correlation of +1.0 is perfectly positive, indicating assets move in lockstep, correlation of 0 indicates no relationship, and correlation of -1.0 is perfectly negative, indicating opposite movement. Generally the more negatively correlated the assets, the more diversification.) While gold straddles the line between a low and moderately positively correlated relationship, a few other asset show more diversification historically.

Real estate and bonds show little relationship with oil with correlations of 0.18 (REITs), 0.07 (S&P Case Shiller) but VIX is the one asset with even moderately negative correlation with oil of -0.32.

Franklin Delano Roosevelt would be disappointed. The US fear index, officially named the CBOE Volatility Index (VIX), has ticked up, averaging 16.4 since the beginning of Q4 2014, compared to 13.5 in the first three quarters of last year. If the story stopped there, we might still be able to look FDR in the eye. But we are in an even worse condition. Contrary to his advice, we are fearing “fear itself,” and doing so at levels typical of major crises, including the financial meltdown of 2008.

How do we know we are this anxious? The “VVIX” tells. The VVIX is an index that measures the volatility of VIX – in other words, the volatility of volatility.

I have seen people shake their heads in disbelief that the quants at CBOE would afflict us with an index so perplexing. If you think the same, it’s worth putting your reaction aside and getting to know this index. It says something interesting.

Here’s what you need to know about VVIX:

1. It uses the same methodology as VIX, but instead of communicating the 30-day implied volatility of the S&P 500, it tells you the 30-day implied volatility of VIX itself.
2. Instead of using options based on the S&P 500 in its calculation, this index uses VIX-based options.
3. In terms of performance, VVIX and VIX are not as closely tied as VIX and the S&P 500. VVIX has spiked at different times when VIX has jumped, but when VIX is low, VVIX bounces around more than you would expect.
4. Like VIX, VVIX is mean reverting, but it reverts to a much higher level. The average for the VVIX since 2007 – the first year when VVIX posted values for every trading day – is 86.1, compared to 21.8 for VIX for the same period.

With all this in mind, let’s take a look at a chart.

What jumps out is that VVIX in recent weeks and months is significantly up, even as VIX has stayed near its average. Why would this be? My honest answer is that I don’t know, but it could stem from the nature of the issues we are facing.

In many of the past crises, we have encountered challenges that were difficult to resolve but easy to define, in terms of timetable and influencing factors. An example would be the US government debt crisis of 2011. We were caught between two familiar political parties butting heads and creating uncertainty around the US national budget. Though we didn’t know the outcome at the time, the source of the uncertainty and the decision points that would determine what would happen in this crisis were widely known.

The challenges we are facing now are different. The drop in the oil price and the tensions between Russia and Ukraine are open ended – there is no known timetable for resolving these two issues – and they are much more complex in nature. The actions of many governments, companies, and individuals will determine how these crises evolve. To channel Donald Rumsfeld, all of this ambiguity creates worry about “unknown unknowns” and fear of fear itself.

Although the overall medical trend rates covering all services have continued to be modest in the S&P data through the 3^rd quarter of 2014[1],  the prescription drug trends have been more volatile but modest prior to mid-2013, but have continued to accelerate since then through September 2014.  On a 3-month basis they have climbed to 11.7% by September (before deductibles, copays, etc.).  Cost pressure on generics and brand drugs (perhaps generated by price concessions on Medicare by the pharma companies) have shown an uptick in the last year, however, the introduction of Sovaldi and other new and expensive drugs in early 2014 (which are now incorporated in our economic forecasts) are further pushing up drug costs.  Furthermore, the impact of deductible/fixed dollar copay leverage can be quite substantial on drug plans and have pushed drug trends to insurers even higher than shown in our forecast worksheet.  The impact of more new and expensive drugs for cancer, cardiovascular and cholesterol in 2015 can be expected to potentially push trends higher than the economic forecasts in our models until it gets completely factored into the data.  Recent anecdotal data seems to indicate that Sovaldi growth may have peaked in the short term, while patients are waiting for the new alternative product Harvoni.  In addition to the high cost of Sovaldi, there are issues about the required additional drugs, and the somewhat higher drug regimen termination rates than in initial trials of the drug that could be causing a slowdown in its prescription rate.  A number of combination drugs for Hepatitis C were expected to become available starting in 2015 that help reduce some of the negative effects mentioned, and some patients may be holding off for these new options.

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[1] We track the LG/ASO trends as representative of underlying trends, since Individual and Small Group are impacted more significantly by the Affordable Care Act (ACA).  Keep in mind that actual trends experienced by plans are likely to be higher than as reported in S&P data.  Trends experienced by large employers on plans that have not changed in the previous year could be higher by as much as 2% or more on bronze level plans and higher by 1% or more on gold level plans due to the effects of deductible and copay leverage.  So risk takers need to take this into account.  In addition, the S&P Indices do not reflect the impact of benefit buy-downs by employers (i.e., higher deductibles, etc.), since the indices are based on full allowed charges.  As noted above, actual trends experienced by employers and insurers in the absence of benefit buy-downs can be expected to be higher than reported S&P trends due to plan design issues such as deductibles, copays, out-of-pocket maximums, etc.   Benefit buy-downs do not represent trend changes since they are benefit reductions in exchange for premium concessions, but they can have a dampening effect on utilization due to higher member copayments, and this can have a dampening effect on measured S&P trends compared to plans with no benefit changes, further pushing up experienced trends relative to those reported in the indices.