June 2014

Helping Clients Hedge Market Risk: Four Important Considerations Roger Masi

INTRODUCTION In addition, theme based strategies (water, social The S&P 500 was up 32% last year and recently media, infrastructure, and clean energy) are now reached a new all-time high. Since the March 2009 common. There are even ETFs based on the level of lows, the market is up 180%. Despite this impressive market .

rally, both institutional and retail advisors must contemplate how to protect client portfolio wealth Overall, the growth in the ETF market presents as many sources of uncertainty remain. The risk advisors with a broader menu of hedging products. environment has changed over the past several This is good news, yet, this innovation poses years. Banks can create instability, challenges. All too often, products are employed is no longer seen as risk free, the China growth without sufficient understanding of the costs and miracle is in question, and Central Banks are actively risks that they carry. Hedging is important and influencing the prices of assets. This is not your advisors must be well educated on the products they father’s market. may need to utilize to protect wealth. In this short

note, we highlight some of the common pitfalls we

Because of these risks, hedging remains important. observe in order to better equip advisors during the History has proven that once a market has next downturn. While hedging can be complicated, experienced a significant decline, hedging strategies we offer the following 4 guidelines. can become prohibitively expensive. But even stable, upward trending markets can present 1. Know the Product challenges to investors looking to hedge. While 2. Know the Payoff Profile insurance is typically not expensive in bull markets, 3. Be Wary of Back tests the opportunity cost of hedging can be high. When 4. Hedge When you can, Not When You Have to markets experience few down turns (as in 2012 and 2013), spending money on hedging can add up, KNOW THE PRODUCT creating performance drag. What if we told you, there was an ETF that had this statement in its disclaimer: Together, the environment for global market risk and the costs to hedging pose challenges for advisors “The long term expected value of your ETNs is zero. seeking to preserve wealth for their clients. If you hold your ETNs as a long term investment, it Fortunately, there are now many alternatives is likely that you will lose all or a substantial available to protect equity portfolios. Among these portion of your investment.” new products, the biggest advancements have come through the huge growth in the market for exchange What if we next told you that this ETF traded on traded funds. Launched as vehicles to trade an average 10mln shares per day? Meet the TVIX, an

equity portfolio as a liquid basket, ETFs now cover ETF created in 2012 to deliver 2x the daily the gamut of asset classes (credit, FX, rates, performance of the VXX, itself an ETF based on commodities) and geographies (Mexico, Europe, market volatility. We are skeptical that investors Japan, Brazil, etc.). using the TVIX and products like it are sufficiently well versed in the factors that drive its performance.

1 Over the past few years, a litany of products has The point, again, is that the USO is not a pure play on emerged: Inverse funds, double inverse ETF’s, funds the spot price of oil. Its performance is also that track volatility, funds that seek to provide impacted by the shape of the oil futures curve. overwriting strategies, etc. These products, often Below we show a graph of the relative performance with hidden fees, obscure costs, and complex risks of the USO and oil front month . This can have adverse and unpredictable impact on a chart shows USO compared to the nearest future portfolio. contract where we see the correlation varies between 80-95% over a two year period: Perhaps no product is more misunderstood than the USO vs Oil Front Month Futures 120 50 ETF on volatility. Launched in 2009, the VXX was the CLJ4 Comdty (2.) Price

45 first ETF based on a mechanical strategy utilizing VIX USO US Equity (1.) Price 110 futures. Investors flocked to the VXX as a means of 40 gaining long exposure to market volatility during a 100 period when the VIX was quite elevated. Eventually, 35 however, VXX holders noticed that during certain 90 30 periods in 2009 and 2010, while the VIX spot price 80 remained unchanged, the VXX position deteriorated 25

70 by ~10-20% per month. This disconnect, implied in 20 the foreboding TVIX prospectus, is the result of the Source: Macro Risk Advisors, Bloomberg 60 15 high "roll cost" associated with the strategy 12/22/09 05/23/11 10/18/12 03/20/14 employed by the VXX and other ETFs. These vehicles pursue a strategy that requires futures contracts to UNDERSTAND THE PAYOFF PROFILE be rolled each month that they expire. This strategy The payoff profile of cash equities is simple. If you is costly when the “term structure” of implied buy X for $50, you have $50 at risk and an unlimited volatility is upward sloping (meaning longer term VIX reward. Investing using cash equities is futures are higher than the VIX itself). This cost does straightforward. Confusion sets in when advisors not imply that the VXX is a bad product, but it does employ options to enhance their clients’ risk/return illustrate that multiple factors must be considered profile. before utilizing a product. One example of this confusion is a In the commodity space, ETFs seeking to provide position, where you take 100 shares of a and exposure to a specific underlying have also run into sell a call against it. The provides similar costs associated with rolling futures. For the seller with instant income (the option premium), example, the USO seeks to track the daily movement while the stock’s returns are capped at whatever of the price of oil through the futures market. By strike the call is sold at. At the same time, losses on doing so, the USO avoids delivery of the physical the downside in the equity are slightly cushioned commodity. Critically, a price discrepancy exists from the option premium received. As a result, between the first and second month futures contract covered call writing is typically characterized as a that will cause the price of the USO to track lower more defensive strategy for owning equities. () or higher (backwardation) relative to the underlying commodity.

2 A second strategy is selling a naked put. Typically Given the identical charts above, it is unfortunate characterized as “picking up nickels in front of a and confusing that the two strategies are steamroller”, the naked put generates option characterized very differently. Despite being premium but is vulnerable to a big sell-off in the considered a “safe” position, the call overwrite has stock. Many investors simply say, “I would never sell the exact same payout profile of the “risky” naked a naked put”. The aversion to the risk often appears put sale. dogmatic, implying that the strategy is simply an accident waiting to happen. It turns out, however, We often see strategies being marketed that appear that the naked put seller and call overwriter have a far better than they actually are. Classic examples great deal in common. In fact, they share the same are the “reverse convertible bond”. Hardly a bond risk profile: capped upside, unlimited downside, as at all, the reverse convertible is simply the we show below in the payoff of the two strategies. combination of a long position in stock with a short call option. The premium for the call option is recast as coupon income, enticing to investors in today’s low yield environment. Here is a story published on Bloomberg that details losses investors suffered in 2012 as the price of AAPL sold off. There is no free money in the market, and advisors must approach strategies like reverse convertibles which appear to provide excess yield with a great deal of caution. Understanding payoff profiles is critical.

BE WARY OF BACK TESTS! Mark Twain said there are “Lies, damned lies, and statistics.” Perhaps he was referring to the Wall Street back test. A common method used to test an investment product or idea, back testing can help advisors understand how a strategy performed over various market conditions. Yet, back tests, like statistics, can be shown to prove almost anything. They are teased, massaged, and retrofitted to demonstrate a degree of alpha in a strategy that simply does not exist. In the words of Josh Diedesch of CALSTRS, “You never see a bad back-test. Ever. In any strategy.” A back test will only show you what the results were for that market, but will very rarely carry enough weight to put the results to use in current market conditions.

3 The overpromise that comes via back testing is At Macro Risk Advisors, we encourage investors to nicely captured in a chart from an article in Barron’s, “hedge when you can, not when you have to.” By which displays ETF performance pre and post this we mean that the when markets are quiet, creation. Many ETF creators have been back-fitting hedging is like “buying flood insurance in a drought”. strategies that have worked well in the past, but But when markets suddenly become uncertain, the once a new ETF is launched, only 51% outperform cost can become prohibitive when you need it most. the broad US market. Incredibly, Barron’s calculates And counter intuitively, it is often most profitable to that the average annualized excess return for this sell options when there is time of great fear. Today’s series of ETFs is 10.3% in the 5 years before quiet markets argue for advisors working with clients inception, but actually -1% in the 5 years afterward! to develop a preparedness plan for the next financial This chart should make us all skeptical about the storm. value of back tests.

EMBRACE THE NFL NFL means “no free lunch.” A saying we all know in finance that means, you get what you pay for. There is far too much over-promising in our industry, as evidenced by how every advisor has one client who wants the impossible—“I want leveraged upside, hedged downside, and I don’t want to pay for it!” Beyond this farfetched, albeit hypothetical example, advisors find themselves at a difficult crossroad— remain fixated on a return target, or risk underperforming the benchmark and losing money on hedging. This is especially true in the low interest rate environment of the past several years.

There is no easy solution here and advisors must embrace hedging with intellectual honesty. Hedging is costly and a portfolio that is more hedged will underperform in rising market conditions as in 2012 and 2013. From the advisor’s perspective, the key is clear communication with clients around financial objectives and the risk/reward characteristics of portfolios. Once this dialogue is established, we believe advisor is in a substantially better position to educate clients around the costs and benefits of hedging.

This document has been prepared by Macro Risk Advisors’ (“MRA”) Sales and Trading Group for informational purposes only. MRA does not publish research reports as defined under FINRA Rule 2711. MRA does not trade proprietarily, and is not acting as an advisor or fiduciary. MRA does not guarantee the accuracy or completeness of information which is contained in this document and accepts no liability for any consequential losses arising from the use of this information. Any data on past performance, modeling or back-testing contained herein is no indication as to future performance. All opinions and estimates are given as of the date hereof and are subject to change. The options risk disclosure document can be accessed at the following web address: http://optionsclearing.com/publications/risks/riskchap1.jsp Please ensure that you have read and understood it before entering into any options transactions. 4