Understanding Volatility and What it means to your Portfolio

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Feb 2013 - Why Volatility impacts our decision-making, What causes it, how it serves as a barometer and tool to forecast market direction, how it follows power-laws typical of cascade dynamics of fluid turbulence, earthquakes etc

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Understanding Volatility and What it means to your Portfolio

  1. 1. HorizonsETFs.com Understanding Volatility: What is the VIX and What Does it Mean for Your Portfolio? February 2013 ETF solutions for every investor™ Eden Rahim, VP & Portfolio Manager, Options Strategist
  2. 2. 2A Member of Mirae Asset Financial Group “Markets are constantly in a state of uncertainty & flux, & money is made by discounting the obvious & betting on the unexpected” George Soros
  3. 3. 3A Member of Mirae Asset Financial Group Outline  Why volatility impacts our decision-making  Distribution of market returns over time  VIX: how is it constructed & why?  What causes volatility?  Volatility as a barometer of market uneasiness or complacency  Volatility as a tool to forecast market direction  New frontiers of analysing turbulence
  4. 4. 4A Member of Mirae Asset Financial Group The Great Modulation Source: Adaptive Markets & New World Order, Andrew Lo – January 2nd, 1926-August 9, 2006 %historicvolatility
  5. 5. 5A Member of Mirae Asset Financial Group Overview  Volatility is about the uncertainty of a possible bad outcome, and how it impacts our decision-making  Our future expectations are impacted by low volatility in an asymmetric way to how it is when volatility is rising: comfort vs. fear  Every investor has a different way of coping with risk and volatility and must find the level with which they can deal with it. Decisions about managing risk are inherently subjective, so a ‘one size fits all’ solution is inadequate.  Over the past year, we’ve designed different portfolio hedges for Canadian insurance company & U.S. hedge fund, each with a different aim to be addressed  Best decision combines your expectations about possible outcomes & preference for payoff
  6. 6. 6A Member of Mirae Asset Financial Group Investors confront Volatility in 3 general ways: 1. Passively – it’s part of all markets and must be endured, 2. Hedge against by taking steps to dampen it by either: I. going to cash, II. diversifying to non-correlated assets & ETFs, III. buying put options or IV. buying securities that rise in value with VIX, 3. Volatility as an asset class - agnostically seeking profit on both a rise and fall in volatility.
  7. 7. 7A Member of Mirae Asset Financial Group About the VIX  Designed by Robert Whaley and launched in 1993  Has become the ubiquitous measure of market Volatility and Uncertainty  It is a measure of the average implied volatility of 8 index options on S&P  Composed or current month ATM and first OTM call and put options, and same for next month  With a week to expiration, the front month is rolled to the 3rd month.
  8. 8. 8A Member of Mirae Asset Financial Group TSX Distribution of Daily Returns Pre-Crisis vs Post Crisis  Distinctly fatter left-tail & smaller percent of small gains Source: HIMI, May 2008-February 2013 Source: HIMI, January 1980 to April 2008
  9. 9. 9A Member of Mirae Asset Financial Group Annual Distribution of Equity Returns is Right-tailed (142 Years) Source: Horizons Investment Management Inc. , Annual Distribution of Returns, 1871-2013
  10. 10. 10A Member of Mirae Asset Financial Group Volatility Cycle: Simmer, Spike, Aftershocks, Decay, Steady-State Source: Bank of America Merrill Lynch Research
  11. 11. 11A Member of Mirae Asset Financial Group What Causes Volatility? Distilling Telegraphed Forecasts  NOT HEADLINES! Fiscal Cliff = Y2K  When stocks become strongly correlated  Widening credit spreads / inverting treasury yield curve  Frequent two-way gaps & swings – even if in a small range  Leverage effect: As equities fall, balance sheet leverage increases  Deleveraging & credit unwinding, leading to illiquidity  Pressing need for hedging: Insurance costs most when your house is on fire  Fight-or-flight fear when bad outcomes seem inevitable & assurances of ‘Experts’ become hot air.
  12. 12. 12A Member of Mirae Asset Financial Group Skew: How Much More you Pay for OTM Puts vs OTM Calls:  Impacts the cost of hedging with options  Reflects relative cost of bearish vs. bullish hedging expectations  Costing the lowest amount for put protection relative to calls in 2 years Source: B of A Merrill Dec 31-95 – Feb 1-2013
  13. 13. 13A Member of Mirae Asset Financial Group Up by the Escalator, Down by the Elevator  Pre-1987 Crash vs. Post crash options ‘SMILE’ Source: JOF, Vol 101, Issue 3, Sept 2011 Pre- and post-crash implied volatility Impliedvolatility (annualpercentage) Moneyness =K/S0-1 Pre crash Post crash 0.10.50-0.05-0.1 14 16 18 20 22 24 26
  14. 14. 14A Member of Mirae Asset Financial Group Rising Correlation of Stocks Causes Rise in Volatility  When a market becomes stressed, strong stocks break down & join weak stocks  Diversification ceases to buffer & most stocks become unstable together  Component volatility rises & each company trades with higher volatility  Indexes face macro & systemic risk offset by dampening of diversification  In contrast, companies have both risks, plus risks such as earnings expectations, obsolescence, competition, pricing, demand, cost of credit, leverage  A stressed market brings these into focus & re-prices company risk higher Source: Bloomberg Data, Horizons Investment Management Inc. November 22,2010-November 22,2012
  15. 15. 15A Member of Mirae Asset Financial Group Volatility is Correlated to 5 Year Corporate Credit Spreads  Regression Of S&P Volatility (VIX) vs IG Credit Spreads (CDX IG 5 Yr) Source: HIMI
  16. 16. 16A Member of Mirae Asset Financial Group Two-Year Swap Spread Vs. VIX  The spread at which 2 year fixed rate is exchanged for floating rate exposure  During poor liquidity or increasing turbulence in the credit markets, floating rates reflect the current credit risk, while those in fixed rates are insulated  So those with fixed rates must be compensated for taking credit risk off the hands of firms that need to exit that risk and go to cash  Note years before the financial crisis in 2008, this spread was rising Source: Bloomberg, 1989-2013
  17. 17. 17A Member of Mirae Asset Financial Group Inverting Yield-Curve Lead Changes in Volatility Cycle by 2 Years Source: Horizons Investment Management Inc., January 31, 1989-January 31, 2013 Inverse 105 – 25 Yield Curve
  18. 18. 18A Member of Mirae Asset Financial Group At Turning Points, Internal Intraday Volatility Telegraph Turbulence  Market becomes internally unstable before turns Source: Horizons Investment Managemenet Inc. May 12, 1997-May 12, 2012
  19. 19. 19A Member of Mirae Asset Financial Group Level of VIX has Implicit Probability Forecast of Future Direction Source: BAMI Unlike equity, the distribution of volatility is heavily dependent on its level, one of the factors that makes volatility more predictable When VIX is higher than its median, future changes are skewed to the left When VIX is lower than its median, future changes are skewed to the right 3 Month Change in VIX Percentageofobservations
  20. 20. 20A Member of Mirae Asset Financial Group VOL-of-VOL (VVIX) More Bounded and Responsive to VIX Changes  Only briefly pays to be long volatility  Volatility mean regresses quickly & spends most of time in low volatility zone  “Just-in-time” hedging has superior pay-off return  Tail-wagging-the-dog: anticipating volatility increases can be costly (Q1:2012)  Variance swap did well in that period Source: HIMI, CBOE
  21. 21. 21A Member of Mirae Asset Financial Group Positive / Flat VOL Curve is Normal & Prevalent  INVERSION tends to signal market lows Source: BoA Merrill Lynch Global Research (March 26, 2004-August 7, 2012) It takes more stress to cause term structure inversion now than in previous years
  22. 22. 22A Member of Mirae Asset Financial Group Hurricane at our Doorstep: How VIX Curves Fluctuated During 2007-2009 Crisis Source: Horizons Investment Management Inc. & CBOE, Data as of April 2, 2007-December 31, 2010 S&P and Phases of Change in VIX Forward Curve During A) Topping B) Orderly
  23. 23. 23A Member of Mirae Asset Financial Group Hurricane at our Doorstep: How VIX Curves Fluctuated During 2007-2009 Crisis Source: Horizons Investment Management Inc. CBOE
  24. 24. 24A Member of Mirae Asset Financial Group VIX Curve Spends Almost 80% of Time in Contango  In year with extreme drawdown, the market looks out and says “This is unsustainable” and prices future Volatility expectations into Backwardation Source: CBOE from January 1st, 2007 through December 31st, 2012 Trading Days Contango Backwardation % Contango % Backwardation 2007 251 177 74 70.52% 29.48% 2008 253 143 110 56.52% 43.48% 2009 252 202 50 80.16% 19.84% 2010 252 223 29 88.49% 11.51% 2011 252 178 74 70.63% 29.37% 2012 221 221 0 100.00% 0.00% Total 1481 1144 337 77.25% 22.75%
  25. 25. 25A Member of Mirae Asset Financial Group Current Volatility Curve Extremely Steep (>80th Percentile) Source: CBOE.com, data February 16,2013-December 20, 2014
  26. 26. 26A Member of Mirae Asset Financial Group Misbehavior of Markets by Benoit Mandelbrot  Father of chaos theory & fractal geometry, turned MPT on its head  Markets are fractal, exhibit self-similarity & scales with time  Markets are more risky than bell curve suggest  Turbulence runs in streaks & clusters  Power laws better explain volatility spikes, as it does cascade dynamics of fluid turbulence, avalanches, earthquakes, solar flares….  Much of what we deem predictable is in fact market noise  Market time is relative, expanding & contracting with volatility
  27. 27. 27A Member of Mirae Asset Financial Group Interestingly, VIX Follows Power Law Distributions  Non-Financial work of Zipf’s law (physics), Navier-Stokes (combustion engine) & Omori (seismology) better explain behavior of Volatility outbursts  Volatility ebb & flows in negative feedback loop until is pushed into positive feedback that results in cascade spikes Source: HIMI
  28. 28. 28A Member of Mirae Asset Financial Group Hedging: PUT Options vs Long VIX Products  Unlike Put Options, VIX products require 4 simultaneous bets: direction, path, volatility increase, & shift in shape of curve 1. Both hedge against downside directional moves 2. Puts respond almost immediately while VIX is delayed 3. Puts benefit if market moves down without increase in Volatility ie. orderly decline, while VIX requires an increase in Volatility 4. Puts are not concerned with the Volatility curve, while a shift in curve may impact where long VIX product is profitable even in down market
  29. 29. 29A Member of Mirae Asset Financial Group Summary  Volatility impacts our decision making, requiring an actionable roadmap  Position for normal volatility, be alert to signs when it’s becoming abnormal  One size doesn’t fit all: every investor has own tolerance & return expectation  Investors greet volatility either passively, to be hedged, or traded  VIX has become the ubiquitous barometer of market uncertainty  Since the crisis, daily returns have become more ‘left-tailed’ distributed  Each phase of volatility must be confronted uniquely: simmer, spike, aftershock, decay, & steady-state  Volatility impacted by: correlation, credit spreads, leverage, yield-curve & fear  Level & curve of volatility is itself a forecast. That can be said of few assets  Cascade dynamics & power laws best explain turbulence of volatility  Tools have existed for a 150 years to dampen & distribute risk  Horizons ETFs offers 3 volatility ETFs HVU HUV HVI
  30. 30. 30A Member of Mirae Asset Financial Group Disclaimer The views and opinions expressed herein are of a general nature and the suggestions are not and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors. Commissions, trailing commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by AlphaPro Management Inc and Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. Please read the relevant prospectus before investing. The Horizons Exchange Traded Products consist of the Horizons Index ETFs ("Index ETFs"), Bull Plus and Bear Plus ETFs ("Plus ETFs"), Inverse ETFs ("Inverse ETFs"), VIX ETFs (defined below) and active ETFs. The Plus ETFs and certain other Horizons Exchange Traded Products use leveraged investment techniques that magnify gains and losses and result in greater volatility in value. These Horizons Exchange Traded Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, which, where applicable, are described in their respective prospectuses. Each Plus ETF seeks a return, before fees and expenses, that is either 200% or -200% of the performance of a specified underlying index, commodity or benchmark (the "Target") for a single day. Each Index ETF or Inverse ETF seeks a return that is 100% or - 100%, respectively, of the performance of a Target. Due to the compounding of daily returns, a Plus ETF's or Inverse ETF's returns over periods other than one day will likely differ in amount and possibly direction from the performance of their respective Target(s) for the same period. The Horizons Exchange Traded Products whose Target is the S&P 500 VIX Short-Term Futures Index™ (the "VIX ETFs"), one of which is a Plus ETF and one of which is an Index ETF, as described in their prospectus, are speculative investment tools that are not conventional investments. The VIX ETFs' Target is highly volatile. As a result, the VIX ETFs are not generally viewed as stand-alone long-term investments. Historically, the VIX ETFs' Target has tended to revert to a historical mean. As a result, the performance of the VIX ETFs' Target is expected to be negative over the longer term and neither the VIX ETFs nor their Target are expected to have positive long term performance. Investors should monitor their holdings, as frequently as daily, to ensure that they remain consistent with their investment strategies. All trademarks/service marks are registered by their respective owners. None of the owners thereof or any of their affiliates sponsor, endorse, sell, promote or make any representation regarding the advisability of investing in the Horizons Exchange Traded Products. Complete trademark and service-mark information is available at www.horizonsetfs.com/pub/en/Trademark.aspx

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