Last week we put on a hedge transaction in our managed accounts by buying an Exchange-Traded Note (ETN) designed to track the VIX volatility index. Like many institutional money managers, we have been cautiously participating in a bull market characterized by enormous liquidity-driven momentum. As the price of the stock market continues to float well above both its short-term and long-term trend lines, each dip in price raises the specter that the market will finally take a well deserved breather, having rallied by close to 70% in the 8 months since the lows set in March of this year. Last week, for the first time in months, the market closed below its 50-day moving average and we thought it was prudent to manage the risk that the market might continue to correct down to its 200-day moving average, a normal event for a correction in a bull market, but would result in a further 11% or greater market decline.
By choosing the VIX (Chicago Board of Options Exchange Volatility Index) as our hedge we were betting that if the market sold off, then volatility would dramatically increase from very depressed levels. Having watched the index jump by about 15% as the market fell to its 50-day moving average, we were betting that it could move an additional 30% or more if the correction continued. Unfortunately, we stopped out of this trade with a 12% loss as the market turned on a dime and headed higher again. Our 4% position lost 12% resulting in a “cost” for putting on the hedge of approximately 0.48%, plus transaction costs, plus the cost of whatever interest we lost from selling cash and bonds to put on the trade (which were minimal in our estimation). We view this “cost” as a very acceptable price to pay for managing the risk that the market is due for a significant correction, even if it didn’t turn out to occur last week. In our view, it certainly was better than selling our current risk positions in an attempt to time a short-term market decline. Buying and selling the VIX was an easy transaction to put on and take off, and while the results didn’t work out, I view the risk and reward of this transaction as not only acceptable, but necessary in volatile markets like these.
In my book, Buy and Hold is Dead (AGAIN), The Case for Active Management in Dangerous Markets, I write that one of the challenges that active portfolio managers must meet is transparent portfolios. By transparent, I mean managed accounts where clients can see the transactions in their portfolio, in contrast to investing in say a hedge fund or a mutual fund where the client does not see the transactions in the fund. The reason that transparency represents a challenge to active managers is that each client can view portfolio transactions through the lens of whatever their personal investment biases happen to be. In this case our hedge position has resulted in a very short-term transaction that resulted in a loss. We will have certain clients reasonably asking for an explanation for this trade…..concerned that the transaction lost so much in so little time. And we will have some of our wealth managers asking the same questions…since they have to explain this to our clients (SIGH). I don’t think anyone will be thrilled when we do a similar transaction the next time the market rolls over so far above its long-term trend line.
