September 2018 Commentary

Hurricane Season

Markets largely hung around the flat line in September in an apparent standoff between benign economic data and negative trade headlines.  Like previous episodes this year, the negative reactions proved to be sharp and short, causing a brief flash of caution from our dashboard in the early part of the month.  Otherwise, it was a quiet few weeks from both a market and trading perspective.     

Surveying today’s volatility landscape, we can currently identify a few potential candidates for “spikes” (small Vol Loops) as well as for more substantial “swells” (large loops).  Examples of each are below.

Likely candidates for short-term spikes include news flow around US mid-term elections, trade (tariffs) and the Mueller investigation.  As with any spike, each of these has the possibility of being quickly diffused or snowballing into something more serious for markets (what we term a volatility “swell”).  Of course, it is impossible to know ahead of time which route these will take, so we will continue to stay focused on monitoring changes in the volatility market to guide the best course of action.

Slower-moving but larger “swell” catalysts include the ongoing rate hike cycle and European budgetary issues centered around Italy.  In contrast to the spike candidates mentioned above, a strong link to financial system health and a lack of well-defined outcomes or expiration dates give these issues greater potential for sustained volatility.  Much like preparing for a hurricane, investors would do well to construct a survival plan in advance.

August 2018 Commentary

The Fed and Market Indigestion

In a move that would typically provoke double-digit responses, the S&P 500’s +3.3% jump in August barely registered for VIX ETPs that are the “raw material” for Alpha Seeker as it seeks out trends in these instruments.  Surveying similar action on the year as a whole, 2018 is now beginning to recall memories of the turn in the last major VIX loop in 2007.

Much like this year, the early 2007 VIX low was followed by a shock in February which resulted in a new, higher floor for VIX even as the S&P 500 went on to make new highs in the fall.  Then as now, the trendless but volatile VIX environment was a challenge for Alpha Seeker which recorded the only negative year in its backtest in 2007.  Neatly fitting our Vol Loops thesis, this was then followed in 2008 by the simulation’s best year.  It is also notable that the largest long VIX ETP (ticker VXX) is still positive on the year as of August for just the third time in the index’s 14-year history and second only to… August 2007. 

In our experience this type of VIX action is an indication that the market is wrestling with big issues, and it is perhaps no coincidence that it is occurring three years into the first rate-hike cycle since 2004 – 2006.  In a world economy saturated with record debt at all levels, it is reasonable to expect the credit cycle led by the Fed to continue to be the major factor for asset prices and volatility.  Whatever course the market takes after its “indigestion” ends, we will continue to take our cues from the dashboard rather than any predictions.

Alpha Seeker Roster Update

To keep pace with the evolution of markets, our ongoing research often involves assessing the compatibility of new financial products with our VIX signals.  As part of this process, we have identified opportunities to express our dashboard signals using a set of equity index products with high correlation to the VIX.  In conjunction with our current stable of VIX ETPs, these index products have the potential to expand the opportunity set for Alpha Seeker while providing improved risk control, liquidity and diversification.

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UPRO vs SVXY since Nov 2010

 The chart at left demonstrates the tradeoffs of one of the products identified in our research. Relative to SVXY (the short VIX ETF currently used in Alpha Seeker), ProShares UltraPro S&P 500 (ticker UPRO) shows similar return potential and a much better risk profile, with the tradeoff of underperformance relative to SVXY during certain market environments.  Using our VIX dashboard to define these environments, both products can be used when appropriate to produce an even more compelling profile for Alpha Seeker.     

Going forward, we’re excited to begin using UPRO and similar positions opportunistically in Alpha Seeker portfolios, subject to the same signals and process that has carried the strategy so far over the past 7 years.  As always, the strategy’s goal is to seek growth which is uncorrelated to stocks and bonds.    

Alpha Seeker In A Post-XIV World

On Feb 5 the VIX jumped nearly 120%, by far its largest one-day spike in history and enough to force the liquidation of XIV (VelocityShares Daily Inverse VIX), a $2B short VIX Futures ETN issued by Credit Suisse in 2010.  Per XIV’s prospectus, to protect the firm’s balance sheet in an extreme VIX move the issuer reserves the right to redeem the note and return cash to shareholders.  On Feb 5, Credit Suisse elected to take this option.

We’ve been preparing for this risk since we started Alpha Seeker over 6 years ago.  Much like an options trader dealing with instruments that routinely go to zero, this risk is quantifiable and is explicitly incorporated in our positioning.  This is one reason why net exposure in Alpha Seeker portfolios averaged less than 15% since the VIX broke below 20 in Jan 2016.  At this exposure, even a completely unmanaged portfolio would lose 10-15% in a catastrophic event, a number in line with the catastrophic risk taken every day by equity investors.  With our management, portfolios not only avoided but profited from the chaos on Feb 5.  Over nearly 6 and a half years the strategy has performed similarly through many other volatility shocks including Brexit (Jun 2016), the Chinese devaluation episode (Aug 2015), the worst start to a year in S&P history (Jan 2016) and the historic turbulence around election night in November 2016. 

Furthermore, well before February we had been very vocal on Twitter (@dynamicvol) and in various interviews (see below) about the need to understand and incorporate redemption risk in any VIX strategy.  Starting in mid-January we are also on the record highlighting operational issues with XIV and on that basis switched to SVXY for short VIX positions while they were appropriate.  While XIV is being wound down, SVXY will go on as before offering an identical exposure to XIV in a different legal format.    

As of Feb 6, Alpha Seeker currently sits at an all-time high, profitable in February and for the year with an enormous opportunity (and the tools) to capitalize on further volatility in the short term, then mean reversion once conditions warrant.  Going forward, we will continue to follow the strategy that has served us well in both calm and chaotic markets over the past 6 years and will continue to use VIX tools appropriately as conditions warrant.