6/13/2017

Note: an edited version of this article first appeared on ETF.com.

Jerry: I hate anybody who had a pony growing up.

Manya: I had a pony!

Jerry: Well, I didn't mean a pony per se...

Manya: When I was a little girl in Poland, we all had ponies. My sister had pony, my cousin had pony. So, what's wrong with that?

Jerry: Nothing. Nothing at all. I was just expressing...

Manya: He was a beautiful pony. And I loved him!

Jerry: Well, I'm sure you did. Who wouldn't love a pony? Who wouldn't love a person who had a pony?

Manya: You! You said so!

Quote from The Seinfeld Show Season 2 Episode 2 – The Pony Remark

 

Not too long after we published our May 2017 Market Commentary commenting on ‘The Death of Volatility’, the Wall Street Journal wrote about the increased popularity of shorting the VIX, or implied volatility priced into S&P options.   With the VIX having dropped to record low levels (Chart 1), shorting the VIX has produced a handsome return so far this year (up 70% based on the ProShares Short VIX Short-Term Futures ETF (SVXY)).  Forget the FANG trade, shorting volatility has become the popular ‘pony’ for institutional and retail traders.  With the advent of exchange-trade portfolios (“ETPs”), now every trader can own a pony, and all the doom-and-gloom naysayers will come across as Jerry in the ‘Pony Remark’ Seinfeld episode. 

Chart 1 – VIX Drops to Record Low Levels

Being long ‘calm and serene’ has turned out to be the trade du jour since last summer’s Brexit vote.  Despite the disappointments over President Trump’s ‘failure-to-launch’ fiscal campaign promises amidst distractions concerning whether the Russians usurped our democratic process, global markets appear to be on the mend following favorable electoral outcomes across Europe and a lack of capital flight disruptions coming out of China.  Indeed, the stars appear to be aligned for a global ‘pony’ regime as even a lack of global natural catastrophes has helped drive down insurance premiums. 

Speaking of which, institutional appetite for catastrophe (“Cat”) bonds has proven to be insatiable in an environment of low event risk and low interest rates.  Cat bonds and Inverse VIX ETNs have both broadened their natural user base to a whole new class of investors, which has helped drive down insurance premiums for protecting against downside risk.  Last August, the Wall Street Journal published a cautionary article on the surging popularity of cat bonds driven by yield-hungry pension plans who were willing to underwrite cat risk at a 6% yield versus the 16% historically targeted by reinsurers.  In complaining about this competitive environment, Warren Buffett of Berkshire Hathaway mentioned that Berkshire had pulled back on its underwriting in the face of an unattractive pricing environment.  Ironically, the reinsurers created cat bonds in order to spread out the event risk, but opening this Pandora’s Box has resulted in a muted environment with “lower prices and poor returns.” 

Fast forward nearly one year later, and the environment hasn’t gotten much better for Mr. Buffett.  According to Artemis, 2017 is turning out to be a record-breaking year for cat bond issuance as “investor appetite for insurance and reinsurance-linked risk appear stronger than ever…”  So Mr. Buffett’s cautionary outlook has largely fallen on deaf ears as the multiple of expected losses to cat bond coupon (Chart 2) drops further, leaving little room to absorb more Hurricane Andrews.  

Chart 2 – Recent Cat Bond Issuance Priced with Little Margin for Error

And in a similar vein, equity and fixed income market risk premia have also narrowed, whether in put option premiums (Chart 3), credit spreads (Chart 4), or even the earnings yield on the S&P 500 (Chart 5- the inverse of the forward price/earnings multiple). 

Chart 3 – Drop in Option Premium Spreads

Source: WisdomTree, CBOE, as of 3/31/2017.  Monthly premiums are calculated based on the option roll date and assumes a fixed $100 investment at each roll.

Chart 4 – Risky Credit Spreads Continue to Drop

Chart 5 – Trailing 20 P/E on the S&P Translates into 5% Earnings Yield

The flip side to poor market pricing is that the consumers of ‘insurance’ are enjoying lower premiums.  Florida homeowners pay lower premiums due to institutional capital competing with P&C insurers for the homeowners’ insurance wallet (why can’t we translate this dynamic to the medical side?).  And companies enjoying high equity valuations and low borrowing costs stemming from a low VIX/low interest rate environment are able to free up their ‘wallet’ for business development. 

That’s not to say that writing insurance this year hasn’t been profitable.  Even shrinking volatility risk premiums haven’t stopped VIX shorters from enjoying outsized returns as evidenced by the 70% return for SVXY or the 1-year uninterrupted upward move in the S&P Put-Write Index (Chart 6).  P&C insurers can still earn handsome returns on capital through their investment portfolios, and a lack of catastrophes means they’re still running at attractive combined ratios.  And if the thinner margins of writing new insurance (collecting option premiums) seem less attractive in this ‘calm and serene’ environment, you can always add on more financial leverage (via 2x or 3x inverse ETPs) to goose your return on capital. 

Chart 6 – A Smooth Ride for Put Writing

How does one explain all this?  Underwriting insurance has been historically profitable because of risk asymmetry or investor aversion to significant downside risk more than what is implied in probability forecasting (as we commented in our 1Q2017 Market Commentary, referring to ‘Embracing Downside Risk’ written by principals from AQR).  For property owners, this aversion to downside risk makes sense because they lack the capital to withstand a major catastrophe, unlike the underwriters.  But investors are generally not as vulnerable; yet, they are constantly chasing that elusive holy grail of full upside capture with none of the downside, which, according to the AQR authors, is the behavior that drives much of the long-term equity risk premium.

Despite this historical aversion to downside risk, whether in property or in markets, insurance premiums are coming down due to several market-wide developments.  For instance, big data initiatives have helped improving forecasting models, whether predicting Florida wind patterns, or macro trends based on the number of cars parked at Wal-Mart.   If the future proves to be a little more certain, then that will reduce the cost of providing downside protection, whether against catastrophes or downside ‘tail’ risk in the markets.  An especially accommodative, coordinated policy of quantitative easing across global central banks is another likely determinant for driving down risk pricing as has the recent geopolitical stability. 

But could it also be that consumers of insurance have grown less risk adverse as we move past the global catastrophe of 2008 (and subsequent aftershocks stemming from the European debt crisis and China slowdown) – a reduction in demand that would affect insurance pricing?  This shift in behavior would be natural as an environment lacking event risk helps shape expectations that such an environment of low/no risk will persist going forward.  Quoting Mandy Xu, derivative strategist at Credit Suisse, “investors are pricing in zero risk in the near term” as complacency has definitely seeped into the pricing of risk. 

This last point is especially notable because it has significant implications for capital market pricing going forward.  Short of a global catastrophe or an inflation scare, the upcoming environment should be characterized by 1) elevated equity market valuations; 2) global real rates at or slightly above zero; 3) narrow risky fixed income credit spreads; 4) smaller option premiums (whether VIX for equities or MOVE for bonds); and perhaps 5) narrower risk premia from smart beta factors such as small caps, value, quality, and momentum.  It’s an environment where Goldilocks can have her ideal bed and porridge along with her own pony, but within a new Normal context (low secular growth) where the Three Bears have lost their appetite. 

We Are All Insurers Now

The ‘We’ is the class of investors who believe in long-term asset allocation despite market volatility.  They earn ‘risk premium’ from other investors unwilling to bear the potential for downside tail losses.  The AQR authors made this astute observation when decomposing the S&P’s return between its covered call component and long call component, concluding that “nearly all of the S&P 500 Index’s return may be attributed to its covered call component” or the insurance premium portion for taking on downside risk.  Yet, the long call position “contributes little reward while still contributing 41% of the underlying market risk.  So, long-term equity investors are essentially writing insurance (covered calls or puts) to asymmetric risk-adverse investors who want upside participation but not the downside. 

Similarly, investing in smart beta amounts to insuring against other types of systematic risk beyond market beta such as size, value, quality, and momentum (this assumes you hold a risk-based view on what’s driving the historical premium as opposed to a behaviorist view).  Corey Hoffstein at Newfound Research best summarizes how smart beta factor premiums are earned by noting that the premiums aren’t free but are generally earned from the premium’s volatility that “causes weak hands to fold, passing the premium to the strong hands that remain.”

With respect to credit risk, the Merton Model helps explain the insurance underwriting nature of fixed income credit risk where owning risky debt can be viewed as 1) owning riskless debt and 2) writing a put option that allows the stockholders to put the assets of the firm to the debt holders without further liability.  Fixed income investors are willing to give up the upside (equity) while asking for excess compensation in the event that the business enterprise fails.

Like the Wall Street wizardry that has produced the cat bond market for institutional investors, the advent of ETPs have broadened the participation pool to those who want to underwrite downside risk protection.  Not only can we all own ponies, but different types of ponies as well which had not historically been available until the advent of ETPs.  Shorting the VIX has proven to be popular because you earn both a volatility risk premium as well as a term premium since the VIX term structure tends to trade in contango (i.e. longer-dated futures are pricier than shorter-dated futures producing a negative roll down yield for those establishing long futures positions). 

Now one can debate whether ‘we’ should choose to participate (via tactical positioning) in writing market insurance if ‘we’ feel the embedded premiums are not sufficiently compensating for downside risk.  That’s a hornet’s nest that this article won’t kick, but suffice to say, current pricing across most risk asset classes implies lower expected rates of return going forward (Jeremy Schwartz, Director of Research at WisdomTree Investments, blogged about this recently).   Active managers are essentially paid to make these kind of assessments, so one could argue that they perform a critical function in the capital market pricing mechanism. 

But for those bemoaning the current low/non-existent risk environment as a sign of complacency, the exercise of investing is all about underwriting risk, regardless of whether it is priced appropriately or not.  Having the appropriate time horizon and ability to withstand the occasional hit to capital from a ‘downside’ event are critical matters to consider, but there is no getting around the insurance function that investors are serving.  You always have the choice to behave like Mr. Buffett and back away if you don’t like what the market is offering. 

Disclosure:

At the time of this writing, 3D Asset Management did not hold positions in SVXY.  The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future.  It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy.  It is for informational purposes only.  The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these.  There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results.  None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk.  The opinions offered above are as June 14, 2017 and are subject to change as influencing factors change.

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