Investors have routinely watched the volatility indicators like the VIX to measure investor “fear” in the market via the implied volatility of the underlying index options. In recent years, they’ve been able to partake in spikes in volatility as a portfolio hedge via the exchange traded notes, otherwise known as ETNs (VXX) and (VXN) which track volatility futures in the broader market and the NASDAQ. But what about when the VIX runs up in spectacular fashion and it’s evident to you at least, that there’s nowhere to go but down? In the past, you’d have to either short an existing long VIX ETF or buy puts, neither of which are appealing. Novice investors are often duped by the futures roll effect in the options, not to mention that most options expire worthless. Now though, there’s an inverse volatility ETF which allows you to buy when there’s blood in the street, if you will.
Ticker: XXV
Expense Ratio: 0.89%
Yield: n/a
ETF Basics:
Cunningly tickered the inverse of the VXX, as XXV, the ETF will basically benefit from market “calm” or seeing investors more confidently buying put options over call options. During extreme market declines, VXX and VXN have spike doubled digits in a single day and had nice monthly returns well into the 20% and 30% range. So, there’s a strong negative correlation with a boost to long market conditions.
When is XXV Useful?
With that in mind, you might be asking, why not just long the market instead of buying XXV if it’s now positively correlated with market indices? Well, the reason is that the market can somewhat meander along while volatility drops. It’s really a trading mechanism rather than a long-term hold.
Some investors like to use technical analysis and trade seemingly range-bound instruments by buying at the bottom of a range and selling at the top. By watching the VIX, some traders discern routine reoccurring patterns that tend to repeat themselves in the absence of extreme exogenous events. Of course, it’s that Black Swan that can wipe out the position, but eventually, market volatility tends to revert to the mean. We saw this following 9/11, following the financial collapse of 2008-2009 and we’ll see it during the next panic. When that happens, rather than going long shares, it may make sense to go long XXV. Now, just because it benefits from a relaxation of fear in the market, that doesn’t necessarily mean that this constitutes a legitimate safe investments like FDIC backed instruments, hybrid CDs, etc. because given an extreme scenario, volatility could remain at elevated levels for months. So, it’s not a guaranteed home run, but when investor fear seems overdone, it could certainly make for a good contrarian investment without the need for shorting ETFs which opens the door to unlimited losses.
Where’s volatility Headed from Here?
It’s tough to say, but it isn’t a stretch to assume that excluding deviations occasionally due to exogenous events, the VIX tends to revert to a relatively tight range. In the news of late, the talk has shifted from hyperinflation to deflation investing and what a European-style US Austerity initiative would do to GDP growth. Whether or not you believe him, today Barney Frank stated that while they’d target 250K earners with tax increases, there would be no VAT (Value Added Tax) implemented in the US which many were fearing. Housing and employment numbers have been mixed of late and stronger than expected earnings have buoyed the market of late, leading many to believe that while the picture may not be rosy over the next several months, a relative calm has at least set in, which would be positive for XXV.
Take Thursday’s trading session for instance. Even though the US broad market indices were all down modestly, XXV actually gained 0.35% on the day. So, it doesn’t necessarily have to be a zero-sum game between XXV and equities, just a slightly positively correlated relationship that benefits from calm investors seeing through the fog of panic and recognizing that over time, the dust always settles.
It’s important to note that ETNs are subject to the risk of the holding company, which in this case is Barclays. The solvency of Barclays/parent is not in question at this time, but anything could happen during another financial crisis. This would be something to keep in mind on top of the fact that you will have lost a bundle on XXV during a precipitous decline anyway, ironically.
Disclosure: No position in any instruments referenced in this article at time of publication.
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During the recent financial collapse, the perpetual bears had their day, crowing about how they were right all along and the US was in for a cataclysmic crash. Their chorus grew especially loud during the March lows, which in retrospect was the worst time in decades to either sell your long positions or enter into a bear market fund. Aside from looking at recent history for their failures, let’s consider the broader liabilities of investing in a bear market fund moving forward:
- You Can’t Time the Market: It’s been demonstrated time and time again that no known investor, let alone retail investor, can predict market direction with any great certainty. Day traders and quants can exploit instantaneous anomalies in market pricing and momentum, but as far as a buy-and-hold investor being able to pick a particular period where it’s good to be long and good to be short, history has not supported such an ability. Otherwise, they’d be running a hedge fund generating triple digit returns annually in any market. For all the progress we’ve made in quantitative modeling, flash trading and hiring the best and brightest minds from MIT to work on Wall Street, the hedge fund industry is actually coming off the worst quarter of the decade (BusinessWeek).
- The Market Can’t Drop Below Zero: While you can double, triple and quadruple your money over time in any investment if you hang on to it long enough and it follows a historical uptrend, let’s say you pick the pivot top of a market for a given time period and invest in a bear fund. The best you can ever do is approach a 100% return. You can never exceed 100%. So, what then? If you believe the Dow is going to drop to below 1,000 in a total economic apocalypse, what then? Mortgage the house and bet that it will drop further to Dow 100? It’s basically the end of the road, aside from the fact that it will not happen short of a nuclear holocaust.
- You Could Do This Yourself: If you’re intent on being short the market, or even hedging a broader portfolio, why would you rely on a higher-priced fund with no real-time disclosure rather than just taking up short positions yourself. There’s everything from using put option strategies to shorting stocks to shorting leveraged ETFs for the most aggressive of risk seekers. There are some very aggressive leveraged short ETFs as well. For maximum volatility, there are the following 3X daily reset leveraged variety: Direxion Financials Bear 3x ETF (FAZ), Direxion Small Cap Bear 3x ETF (TZA), Direxion Technology Bear 3x ETF (TYP), Direxion Emerging Markets Bear 3x ETF (EDZ), and Direxion Real Estate Bear 3x ETF (DRV) – not only do these combine 3X daily leverage, but the underlying sectors are more volatile than broad market indices like the S&P500. But you can do these tailored to your own needs and without annual fees (albeit commissions), as opposed to banking on the right calls being made by fund managers.
- Performance Isn’t Impressive: Let’s consider a prominent bear fund – Federated Prudent Bear (BEARX). While it got clobbered coming off the March 2009 lows and stands at -32% vs. a gain of 57% for the S&P500 (SPY), that is to be expected. However, in looking at periods where you would have expected strong performance, it’s just not impressive either. This year for instance, SPY is down for the year by about 3% – well so is BEARX – down 2% as well. So, what are you paying for? For a fund that’s supposed to thrive in a down market, with the flexibility to shift in and out of various assets and cash, you’d think it would at least be positive on the year. And don’t even get me started on holding leveraged ETFs for long periods of time. Even holding a bear market ETF while the market declines doesn’t guarantee you’ll make any money due to the mathematical certainty of value decay I routinely warn about.
While many of the bear funds will purport to have asset class diversification, know when to get in and out of cash vs. shorting stocks, etc., I just haven’t seen evidence that these funds can or will outperform the market in the long-term. And if the thinking is that they will outperform in a down market (which they’d better with a name like that), then what are the odds you, as a retail investor, can time when to enter and exit the fund? As I mentioned above, it’s almost 90% in the timing of entry/exit and a small portion of what the actual short positions are that will dictate success or failure. Investing for income vs. capital appreciation is one thing, but trying to distinctly time the market by entering and exiting a bear fund, on top of anticipating that the fund manager will time it right as well…is an exercise in futility.
This is not to say that the only direction for the market is up, and frankly, I’m surprised it’s held up as well as it has with credit availability unlikely to improve in the face of the worst FICO Score report we’ve ever seen indicating now fully 1/4 of all Americans are below 600, but who’s to say that’s not already baked into current equities prices and from here, we’re just as likely to move up as we are down? The point is that over the long term, you’re much more likely to make money long then you are short. If you’re that concerned over the direction of equities, perhaps stocks aren’t for you and safe passive investments should be the sole components of your portfolio.
Disclosure: No long position in any investments covered in this article. Author is short multiple leveraged ETFs in pairs trades including: FAZ, TYP and DRV.
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It’s been a busy couple weeks for new ETF launches so I thought I’d highlight some of the newest to the crowd:
Leveraged ETFs
Direxion has launched 4 new leveraged ETFs focusing on natural gas and retail.
- Direxion Daily Retail Bull 2X Shares (RETL)
- Direxion Daily Retail Bear 2X Shares (RETS)
- Direxion Daily Natural Gas Related Bull 2X Shares (FCGL)
- Direxion Daily Natural Gas Related Bear 2X Shares (FCGS)
Each of these ETFs carries a 0.95% expense ratio and will act similarly to the myriad other daily reset leveraged ETFs out there. As far as retail, the sector could really swing dramatically one way or the other in the coming months given what’s going on with home prices, unemployment, the upcoming election cycle and US Austerity which is ultimately heading our way, all of which will have an impact on consumer sentiment to be sure.
I love to hear about new ETF launches, not because they’re good investments, but because they’re bad investments long term. What? Due to the mathematical certainty of value decay over the long term stemming from daily resets, I short 2x and 3x ETFs as an alternative investment asset class in my own portfolio. The returns are generally non-correlated with the broader market because I short them in pairs. The performance on the long side is so abysmal that they routinely require reverse splits to boost their share price out of the single digits. See more about reverse splits and why they all go to zero.
ETF of ETFs
Taking a page out of the fund of funds approach, the Mars Hill Global Relative Value ETF (GRV) actually takes a long-short approach to various areas around the world. The fund seeks to exceed the average annual return of the MSCI World Index by overweighting areas they view as attractive, while underweighting areas that are unattractive. Based on the long-short approach, the fund will seek to capitalize on the spreads between the long and short positions. As this is an active approach and requires insight into which way particular markets are going to head, I’m a bit skeptical as to whether the fund can deliver above-market returns. I’ll have to wait and see.
India
Emerging Global Shares Indxx India Small Cap ETF - This small cap India ETF (SCIN) seeks to replicate the returns of the Indxx India Small Cap Index which has 75 publicly traded small caps all in India. IT and banking are the predominant sectors in the fund which carries and expense ratio of 0.85%.
For London Exchange Investors
RBS will be launching a series of new ETFs on the London exchange covering a both countries/regions and commodity indices:
Dax Russia
Dax Bric and Dax
Asia indices
Jim Rogers Commodity Index
Jim Rogers Metal Index
NYSE Arca Gold Bugs Index
That’s just a few of the ETFs coming our way this summer. Make sure to check out the New ETF Review thread for more as they come.
Disclosure: No position in any ETFs covered in this article.
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It was a tumultuous week in the market with events ranging from the Goldman settlement and disappointing earnings elsewhere in Financials to Apple’s mea culpa to less than stellar jobs numbers. Broader indices ended the week slightly down with the S&P500 (SPY) losing 1.2% and the NASDAQ (QQQQ) losing 0.6%. Volatility picked up and the Euro started to pare back losses as fears over a dissolution of the Euro started to subside in the face of various Austerity Measures (EU country by country comparison) moving forward. With that backdrop, I always like to highlight both the best conventional ETFs and Leveraged ETFs of the week so as to realistically portray the happenings in the market on an unleveraged sector basis:
Hottest Non-Leveraged ETFs:
TZA – Direxion Daily Small Cap Bear 3X Shs – Up 7% – Given that small caps are notoriously more volatile than the broader market, it stands to reason that in a down market week, TZA should have a strong showing. Small cap investors are still concerned over the lack of access to credit, what impact the health care reform mandates will have on small businesses and the return of the consumer. So, any bad news sends TZA spiking.
SMN -ProShares UltraShort Basic Materials – Up 7% - Given the similar theme of negative market sentiment during the past week, it didn’t bode well for basic materials prices. With housing stagnant and various stimulus programs winding down, investors are fearing stagnant materials prices for everything from concrete to copper wiring demand. If concerns over housing and economic growth persist, it may be worthwhile to consider high yield utility stocks for lower volatility and high dividend payouts to ride out further volatility.
FAZ - Direxion Daily Financial Bear 3X – Up 7% – FAZ is a common participant on this list alongside its counterpart, FAS (Long). Financials have been incredible volatile from 2008 onward given the precipace of collapse and then the stellar recovery off those lows in 2009. This week was a volatile one given Goldman’s (GS) settlement over its behavior related to mortgage backed securities sales that many analysts and pundits alike hailed as surprisingly low. While Goldman rallied 6% on the week, Bank of America (BAC) tanked 8% due to lackluster earnings, taking much of the banking and investment house sector down with it. Even in the face of astounding low mortgage rates including a shrinking jumbo spread (current best rates in your area), housing just isn’t moving the dial and many investors fear with the expiration of the new homebuyer tax credit and a recent report outlining a massive drop in credit scores of Americans this year, we’re looking at a new leg down in housing, which could crush Financials again, especially in the loan loss bucket.
Hottest Leveraged ETFs:
VXX – iPath S&P 500 VIX Short Term – Up 7% – The “fear index” was up this week on investor sentiment, especially with a big down day on Friday where most of the gains from the week came from (up over 6%). VXX can spike upwards of 20% on a given day, but this is really an inverse play on the market at large. In general, VXX will surge in a down market, and as investor complacency sets in, VXX will gradually dip lower as the market rises.
GXG – Global X InterBolsa FTSE Colombia20 – Up 4% - Colombia, one of the Frontier Markets (see next ETF reviewed below) has been performing quite well year to date, at a 28% gain vs. a 4.5% loss for the S&P500. Investors view the country as pro-growth, pro-business and conditions have improved dramatically over the years from the cliche crime, kidnappings and drug trade. Business is strengthening and Colombia doesn’t have the same debt woes as the developed nations.
FRN – Claymore/BNY Mellon Frontier Markets - Up 1% - With the backdrop of a small loss in US equities, this Frontier Markets ETF was able to squeeze out a gain. Unlike past debt implosions, rather than the emerging markets (and in this case, the further removed frontier markets) acting as a catalyst for a global panic due to debt problems, this time around, it was developed markets. Investors aren’t ignoring that the balance sheets of many of these countries actually look healthier than those of the US, Europe and Japan. Year to date, FRN has returned over 4% while SPY has lost over 4%. See full review of the Frontier Markets ETF for more background on holdings and performance.
Disclosure: Author is long GXG as a long-term hold. Author does have a market neutral short leveraged ETF position in FAS/FAZ.
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I was a bit skeptical when I started to see “actively managed ETFs” popping up over the past couple years, so I thought I’d take a look at one of the larger ones and see how it’s performed vs. the broader market. In looking at the PowerShares Active AlphaQ (PQY), I was actually surprised by what I found. The fund invests in 50 NASDAQ-listed securities using proprietary methodology for weighting and trading. With the NASDAQ as its benchmark, I found that the fund beat out (QQQQ) in all recent time periods both up and down – and the S&P500 (SPY) as well incidentally.
Actively Managed ETF Key Statistics
Ticker: PQY
Expense Ratio: .75%
Assets: $21 Million
Return 1 month (vs. QQQQ): -2.2 vs. -2.9
Return 3 month (vs. QQQQ): -8 vs. -9.5
Return 6 month (vs. QQQQ): 0.5 vs. -1.1
Return 12 month (vs. QQQQ): 29 vs. 23
Actively Managed ETF Top Holdings:
Millicom International Cellular S.A. 2.82%
Citrix Systems Inc. 2.82%
DIRECTV 2.60%
Netflix Inc. 2.57%
NetApp Inc. 2.46%
Ross Stores Inc. 2.46%
O’Reilly Automotive Inc. 2.44%
priceline.com Inc. 2.42%
Express Scripts Inc. 2.40%
SanDisk Corp. 2.35%
Impressive Returns
This actively managed ETF is doing something right. In all time periods evaluated, both up and down, PQY exceeded its benchmark index. In looking for a dividend yield, the fund has not payed out any dividends to date. When comparing the .6% dividend yield offered by QQQQ and the lower expense ratio, as long as the fund is outperforming by 1% annually, it appears to be paying off. At this point in time, the 1 year difference in performance is 6%, making a strong case for consideration of PQY.
Words of Caution
I couldn’t help but notice the ETF has very little trading volume, so little in fact, that sometimes hours go by without a single trade. So, what you run up against there is a lack of liquidity when you’re trying to unload shares and also the possibility of a wide bid-ask spread. So, you’ll want to proceed with caution if entering into a sizable position. Additionally, since the fund is comprised of NASDAQ stocks, it will tend to more more volatile than a broader market index like the S&P500 and of course, other safe investments with lower volatility that rely on income for net returns rather than capital appreciation. You’ll find no AAA Companies in this mix, but over time, the S&P500 and the NASDAQ don’t tend to diverge too much, just more of a Beta issue than anything else. Finally, the fund is relatively new and unproven and of course the mantra regarding past performance vs. future returns applies. However, based on several data points in both up and down markets, as it stands now, PQY makes the list of the Hottest ETFs beating the benchmarks.
Disclosure: No position in PQY
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