Divergence From Fundamentals Keeps VIX On Edge
A deterioration in the broader economic picture was masked by the Fed’s dovish turn in 2019, as the S&P 500 recovered from last year’s sharp drop despite a decline in earnings on the year. US Small Caps (the Russell 2000 index) fared similarly, posting double-digit gains in 2019 on a -14% decline in earnings. Such is the power of perception.
S&P 500 Price vs Earnings. Source: @sentimenttrader
Remarkably, equity indexes were also able to look past other notable warning signs including sub-50 readings in the Purchasing Managers Index (PMI), an annual contraction in US industrial production and an inversion of the US Treasury yield curve, a signal that has preceded each of the last 7 recessions in the US.
VIX Index 18-20 Crosses. Source: CBOE, TCM
The wide divergence between prices and fundamentals has kept hedging activity robust since early 2018, resulting in a hyperactive VIX that crossed the 18-20 “transition” zone an astounding 30 times in 2019 alone (see chart). For TCM strategies, migrations through this area typically result in turnover of defensive positions that can create a drag in back-and-forth markets that have become more common during this period.
market “insurance” premiums ON THE rise
Growth of $1000, since inception as of 12/31/19. Click for larger image.
“Hedged Equity Peers” is an equal-weighted composite of Swan Defined Risk (SDRIX), JP Morgan Hedged Equity (JHEQX) and Gateway Fund Cl A (GATEX), rebalanced monthly
During 2019, the caution suggested by fundamentals was not ultimately reflected in market prices, making defensive positions and strategies particularly challenging. This increase in “insurance premium” was perhaps most clearly reflected in the Hedged Equity universe, where a composite of Hedged Equity funds representing $16B in assets trailed the S&P 500 by over 15% on the year through November (see chart). By way of comparison, this same composite matched the S&P return in 2018 and trailed by just 10% in 2017, primarily as a result the varying cost of protection in those years.
defense does not pay in 2019
In general, the most aggressive strategies came out on top in 2019, and TCM strategies were no exception. The “lighter touch” of its tactical hedging approach helped Smart Index to limit hedging expense and substantially outperform its Hedged Equity peers this year, with the strategy still retaining a cumulative hedging profit since inception in 2016. A strategy well-suited for choppy markets, covered calls added approximately 30 basis points to the year’s return for Smart Index accounts using that feature.
With its naturally less-aggressive diversified approach and following a mid-year pivot toward more defensive positioning, Legacy Navigator posted moderate gains on the year and continues to outperform a standard 60/40 portfolio with less risk since inception.
Taking its cue from the VIX and without an index exposure “ballast”, Alpha Seeker proved too defensive for 2019, particularly in the first quarter when the VIX was slow to normalize during the S&P 500’s sharp recovery from its year-end rout. Similar to 2014, this year’s series of rapid, headline-induced “Vol Loops” disrupted the typical trends in VIX products that form the basis of Alpha Seeker’s return. As it has done for over eight years, during this adverse environment Alpha Seeker was able to limit exposure and still remains within striking distance from new all-time highs. With the stock market a decade into the longest bull market in history (see chart), now may be a good time to reconsider your portfolio’s reliance on rising equity prices.
S&P 500 Bull & Bear Market History, 1900-2019. Source: Goldman Sachs
alpha seeker strategy’s next evolution
The name “Alpha Seeker” refers to the general strategy of using our Volatility Dashboard for trading VIX products, whether VIX futures directly or through vehicles like VIX options or ETPs (Exchange Traded Products). Since we designed the strategy nearly a decade ago, we’ve traded it in every form, from sophisticated institutional portfolios using futures and options, to streamlined managed accounts using only long and inverse ETPs. While each approach is managed using the same strategy, the investment vehicles used to implement the strategy can produce noticeably different risk/reward profiles.
As we’ve discussed, consolidating markets can be a challenge for the Alpha Seeker approach. This is particularly so in the managed account format which is limited to trading VIX ETPs- linear exposures which may work well for capturing trends but are sensitive to sharp reversals common in consolidating markets. During these periods, we’ve found that portfolios utilizing the strategy can benefit from the flexibility afforded by options and futures.
While the flexibility to use ETPs, futures and options may be desirable from a strategy standpoint, implementing it in a managed account is simply not practical for most advisors. To address this limitation, we’ve partnered with Little Harbor Advisors LLC in Marblehead, MA to launch a new solution in Q1 2020. We’ll have more announcements as we get closer to launch. In the meantime, please contact us with any questions.