It Was A Bad Week For Volatility
By Roger Nusbaum, AdvisorShares ETF Strategist
The dip/correction/crash of the last couple of weeks has provided a useful litmus test for certain alternative strategies, it has reminded us how risky some of the more complicated strategies can be and reminded us that equities are not a one-way trade; after nine years of going up, maybe after peaking at 2872 the path to 3000 on the S&P 500 or even 4000 includes a trip down to 2000 first.
My take on this event, posted in a few different places has been that this is a fast decline, essentially a panic and the historical tendency of fast declines is that they resolve quickly, they have tended to be better to buy. I would be more concerned about slow declines that don’t engender an emotional response. This is something I have written about a couple of hundred times. Anything can happen of course, so the best thing is to stick to whatever investment process you thought was best for you when emotion wasn’t in play.
Probably everyone knows about the deathblows or almost deathblows to the inverse VIX funds. Then there was the saga of the $700 million LJM Preservation & Growth Fund (LJMIX) which views volatility as an asset class and as part of its strategy sold puts on the S&P 500. Selling puts at a high is a very risky proposition. The fund fell 80% last week.
Shorting volatility and harnessing it as an asset class are both very sophisticated strategies. That some funds blew up doesn’t make the strategies any less sophisticated. The idea of shorting volatility seems extremely risky to me. The funds that do it were up triple digits last year versus twenty whatever percent for the S&P 500; 100% in an up 20% world should tell you its risky before you even try to understand the strategy. LJMIX says it tries to profit from the difference between realized and implied volatility. Before even knowing how they do it, just that description sound complex and sophisticated. Then digging in and seeing it sells options would hopefully be a clue to a lot of risk.
Risk isn’t bad or good per se, but an investor needs to understand the risk they are taking. LJMIX purported to have a low correlation to equities. People believe the cryptocurrencies have a low correlation to equities. I don’t doubt that either one, along with many other alternatives have a low correlation to equities but at what risk?
Both the short volatility funds and LJMIX are plays on volatility. Not expecting a blow up, hopefully it would be clear that they are vulnerable to similar adverse market events. Everything is vulnerable to something or multiple somethings and it is crucial to understand the vulnerabilities you’re exposed to in your plain vanilla exposures as well as your exposure to alternatives if you use them.
Some who had 10% each in short vol and LJMIX has endured a serious impairment of capital. It is this exact scenario why I always say to only use 2-3% for any given alternative strategy and make sure you avoid overlaps like the one mentioned above.
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