Morningstar Advisor - April/May 2012 - (Page 42)

Spotlight The Fear Bubble By Paul Justice A mad rush of assets into short-term fear-index products distorts the VIX market. Be careful which asset classes you open up to the masses. They just might buy them. That is advice for those ambitious exchangetraded product providers venturing into esoteric corners of the market. It is also a warning that the folks at boutique firm VelocityShares likely didn’t think they would have to consider. In late February, the fund provider’s backing bank, Credit Suisse, stopped issuing new shares of VelocityShares Daily 2X VIX Short-Term ETN TVIX, which provides leveraged exposure to the Chicago Board Options Exchange Volatility Index (VIX), otherwise known as the “fear index.” Demand was perplexingly too strong. Many would argue that collecting too many dollars is a great problem for an asset manager to have, so the sudden closure raised questions. Why did investors run en masse to own short-term VIX futures tracking products in the first two months of 2012? And was the interest in these products really so strong as to justify shutting down the twice-leveraged note? Once the ETN essentially became a closed-end note, why did investors still demand it enough to push its price to a 15% premium over its net asset value? And, finally, why at times is there more money in short-term VIX tracking funds than there is in the actual VIX futures market? You Never Know What Some People Will Buy The answers to these questions may never be known, but it’s not that advisors and investors are a gullible bunch that will buy anything. They’re quite a particular group. Perhaps the digital age has simply empowered them to a point of overconfidence. Advisors today have more analytical tools and data at their disposal than most institutions had 15 years ago. Armed with this power, advisors theoretically can execute complex yet academically sound strategies. Our research suggests that the results they’re getting are mixed. Advisors are skilled at selecting good funds, but problems still abound in getting the mix right. Also theoretically, volatility as an asset class is an excellent diversifier for a balanced stock/bond portfolio. Its highly negative correlation to equity and credit markets provides impeccably timed zigs for market zags, and the size of its moves are often adequate to ensure that even a small position in volatility matters when it counts. So much for theory. In reality, properly performing a volatility asset-class investment strategy has proved to be mission impossible. In this article, we will investigate the prospects for volatility investments, address why investor demand can be rational despite some atrocious historical performance, and ultimately ponder whether or not the market can handle the demand. Initial Cause for Concern All too often, we witness product providers launch new funds at times when investor demand is feverishly high but the return prospects are past their prime—classic performance chasing. The first volatility ETFs may take top prize for most poorly timed launch from a performance perspective: Their inceptions were in January 2009, less than three months after the VIX peaked at 89.5. While it is well known that the correlation of returns to previously uncorrelated assets goes to one during a deleveraging crisis, such is not the case with volatility. In fact, the timing of the jumps in volatility investments is the only positive aspect of this abstract asset class. In most investments, we seek positive risk-adjusted returns for the asset class independent of the rest of the portfolio. With volatility investments, we fully expect to lose small sums of money during most periods with the hope that positive jumps will be large enough to ease the pain caused by disaster in the rest of the portfolio. This is a form of portfolio insurance not unlike a policy taken out on a real asset, such 42 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012