Alternative Investments: Why do we care?

Have you ever gotten into an argument and thought of the perfect ‘come back’ line a days later, or wish you had said something a little different in an interview or on a first date. Well, our CEO Jeff Malec was invited to present at a “Lunch & Learn” (whatever that is…) put on by Advocate Asset Management, proprietor of the EVO volatility strategy, and their partners Aegea Capital this week. Thing is, he wasn’t a huge fan of his spiel, having one of those ‘a ha’ moments on the walk back to the office where you think, I should have approached it this way.

You usually don’t get a chance to say it again (especially on that first date), but when you have your own blog… well, then there might just be a chance. Here’s Jeff’s revised speech, getting into why we’re all worried about this alternative investment stuff in the first place.

I’m a philosophy major, so I’ll begin by asking – what are we all doing here? Ignoring the existential answers to that question and focusing just on the investment world – we’re all here because we have a problem.

The problem is – we’re most all “naturally long” stocks, meaning that even when we don’t have a direct investment in stocks and benefit from share prices rising; we have indirect exposure to the stock market via our jobs, the real estate market, corporate bonds, and even commodity investments tied to how the global economy is doing.  That’s a problem because the stock market is known for some rather big down moves and bouts of scary volatility (see the dot.com bubble and credit crisis as the most recent examples).

The game anyone who worries about such things plays is finding and creating investments which can reduce the risk of these volatility spikes and big down moves. We all want to sleep a little better at night (and get some better performance and earn some fees, it’s not all altruistic). So how can you do that? How do you protect a stock heavy portfolio? The basic options are: Do negatively correlated stuff:

• Exit stocks all together
• Buy insurance (puts)
• Invest in negatively correlated strategies (short bias hedge funds, buy VIX futures)

o   Invest in non correlated stuff

• Commodities
• Hedge Funds
• Managed Futures

Turns out this isn’t that easy of a game, however; as there are issues with both approaches. The problem with investing in negatively correlated stuff (puts, short bias, VIX) is it’s expensive. It will perform when you need it to, in the bad times – but it costs too much during good times, either through paying premiums or missing out on gains or holding a decaying asset; creating a scenario where you have to get the timing just right in order for the economics to work out.

And the problem with non correlated stuff is that it won’t always be a hedge. Many people confuse non correlation with negative correlation. Non correlation means an investment will do something different (on average), that’s all you know. That ‘on average’ part is the killer, as it means the correlation will sometimes be positive and sometimes negative, averaging out to around zero correlation (non correlated).  Problem is, we don’t live in a world of averages. We feel pain in real time, not on a smoothed, average basis – so when our non correlated investment becomes highly correlated over a short period of time, such as we saw in real estate, commodities, and hedge funds in 2008, it’s at best frustrating – and at worst a disaster for the portfolio.

What investors really want in an alternative investment is the best of both worlds. They want negative correlation during down turns, and positive or no correlation the rest of the time. But how do you do that absent a crystal ball allowing you to perfectly time the market. How do you this ‘best of both worlds’ hedge?

The poster child for such a ‘best of both worlds’ hedge has been Managed futures, which have historically been able to make some money during stock market rallies, and make a lot of money during market crisis periods (past performance is not necessarily indicative of future results… which we’ll see in a second).  Managed futures have historically been slightly positively correlated in up markets and negatively correlated in down markets.

How did they do this? It isn’t magic. They mainly use a systematic, “long volatility” approach which goes both long and short upon a market seeing increased volatility and breaking out of its current range, and spread bets over many market sectors such as grains, energies, currencies, bonds, and even stock indices so something they track is always moving. The trick during stock market rallies when there was little to no volatility, was to compensate by extracting volatility breakouts from other sectors.

That all sounds great, but there’s one little problem – it hasn’t been working of late. Fast forward to today, and you can see that it’s not just the VIX and stock market volatility that’s low. It’s prevalent everywhere. We’re seeing the smallest ranges in the 10yr Note in 35 years. The smallest annual move in Crude Oil in 20 years. Currencies in the 5^th percentile (95% of cases higher) of historical implied volatility. There is complacency everywhere, and that is has hurt managed futures ability to make money when stocks are rallying (especially the larger programs which trade mostly financials). Traditional managed futures programs backup plan for a low volatility, non crisis period market isn’t contributing as it has in the past.

Which brings us to Advocate and Aegea, who have attempted to design a solution for this problem. They don’t try and beat the slow, low volatility times with multiple market sectors and hopes of volatility being present elsewhere. They do it with market structure. What do they mean by that? In the simplest sense, that there is a defining characteristic to some markets, their structure, where the asset has a built in decay in value or built in curve where nearby prices are higher than further off prices, and so forth.

In the case of short options and short Vix futures, the market structure will, by definition, provide return during periods which aren’t good for a strategy designed to profit when volatility spikes. Of course, this is nothing new – option sellers have been ‘picking up pennies in front of the freight train’ like this for years. The difference here is, they are not just cognizant of the risk of the train coming down the track in the form of a volatility spike, they are planning for it.

They know the risk to being positively correlated to stocks via market structure during low volatility times is you won’t be negatively correlated when the spike comes, and have designed their models to do something about. They try to be net long volatility (yet still able to collect premium) by being short it on the front end and long it on the back end on the securities side,  and being dynamic in their exposure on the VIX futures side, with the ability to switch to long VIX should their indicators signal a rising volatility environment. But enough from me, let’s let them explain just how they do that.

Thanks to the team at Advocate and Aegea for the lunch (and the learn).