Authored by John Coumarianous via RealInvestmentAdvice.com,
Frustration with a decade of low bond yields can cause investors to sabotage their portfolios.
The Wall Street Journal reported today that low bond yields has pushed institutional investors like the Harvard University Endowment, the Employees’ Retirement System of the State of Hawaii, and the Illinois State Universities Retirement System to make bets on market volatility. Specifically, the institutions used options contracts to bet on continued and ever increasing market calm.
Some also invested in ETFs designed to short (bet against) the Cboe Volatility Index or VIX, a measure of expected turbulence in the S&P 500.
The article quotes Alberto Gallo, a portfolio manager at Algebris Investments in London saying “Our fear is when these strategies unwind.” He estimates there are more than $500 billion in strategies depending on stock market volatility remaining low, though it’s difficult to track exactly how much money is in this bet.
Institutional investors have flocked to these strategies because they are under pressure to generate returns of 7%-8%, year in and year out, according to the article.
Unfortunately, the ProShares Short VIX fund (SVXY), which many institutional investors own to make their short bet on volatility, reported a jaw-dropping 97% drop in its net asset value last week, when the stock market dropped and volatility jumped, according to the article. Morningstar reports that the fund is down 90% for the year through February 13th.
Lessons to Learn from Harvard’s Blunders
One lesson individual investors can learn from these institutional blunders is to stick to your financial plan, and don’t worry about posting a particular return number every single year. Market returns are typically lumpy, and that’s fine. Retirees need to be cognizant of protecting the downside, as I argued in this post. Severe losses can destroy a portfolio that is in distribution phase, even if they are matched by robust gains in other years. But a small loss or a modest gain that doesn’t match your withdrawal rate on occasion is fine. The attempt to engineer a particular return every year can result in disaster.
The other lesson for smaller investors is that markets are rarely as calm as they’ve been in recent months and years, last week notwithstanding. As I wrote recently in another post, we’ve had return and volatility characteristics that matched Bernie Madoff’s fraudulent ones. Don’t get spoiled into thinking returns come so easily. When these bets unwind, the volatility will likely be intense – just as it was last week.
Nobody knows when that will be. But you should be prepared for it.
We live in a strange financial world with record low interest rates, and investors should understand how unique it is – and how its unwinding will also likely be unique.
As Vitaly Katsenelson wrote in a recent post, “Warren Buffett – the Oracle of Omaha himself – admitted that he doesn’t know how the QE [Quantitative Easing] experiment will end. And if you think well-meaning economists running central banks know, you may have another thing coming.”
Last, investors should think about this strange short-volatility bet in the context of the insurance business. Insurance companies accept premium payments to insure future risks. If they making accurate calculations, they are taking in enough premium to cover the inevitable claims they will have to pay. If they are not, the claims will bankrupt them.
Similarly, in the Big Short, some investors accepted premium payments to insure mortgages that ultimately went bad. The protagonists in the book and movie, by contrast, were on the other side of the trade; they were paying premiums to insure the bonds and get paid when the bonds went bad. Obviously paying for insurance in that instance reflected better judgment.
In a sense, investors who are “short volatility” or betting on volatility to remain low are accepting a premium payment to insure against an event that they think will not occur – a big market downturn or the return of volatility. Do you really want to bet that you won’t have to pay out someday if you’re short volatility? Do you really want to bet that volatility won’t return, or that you’ll be adept enough to get out of the insurance business just before the claims have to be paid? Consider the argument that when things are clam, and insurance gets cheap, the thing to do is buy it, not sell it.
via Zero Hedge http://ift.tt/2ErqYcN Tyler Durden