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Cuffelinks Newsletter Edition 240

  •   16 February 2018
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Before 2007, few people had a clue what a Collateralised Debt Obligation (CDO) was. When cash funds that held CDOs froze redemptions as the market collapsed, the loss of confidence drove what became the GFC. Suddenly, not only was mainstream media explaining CDOs, but so did bestselling books and Hollywood movies, the highlight being Michael Lewis's excellent The Big Short.

There's a scramble now to explain XIV. Bring on Lewis's next book. One day after the CBOE Volatility Index (VIX) had its largest-ever one day rise of 116%, Credit Suisse announced it would close its inverse VIX note. This VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ code XIV) lost 96% of its value on one day. It's arcane to most Australian investors, but this was a $2.5 billion listed note that many local traders enjoyed as it returned 150% per annum for the previous two years.



What happened? In brief, until the start of 2018, equity markets had enjoyed years of falling volatility. Traders used products based on the value of the VIX (the VIX is an index and cannot be directly bought or sold) to sell at say 20, and buy back at say 12 as volatility fell. The inverse note, XIV, traded on the market just like a share, and as the VIX fell, XIV increased in price. Where there's demand, Wall Street creates a product.

But many traders had forgotten about risk. As volatility returned to the market, VIX rose dramatically, and the inverse note, the leveraged XIV, collapsed.

This 'shorting volatility' strategy paid for many a Porsche out of trader bonuses. Discussion website Reddit has a 'Trade XIV' group with 1,800 members, which carried posts like: "How I made $356K on XIV in two years". Now it includes this post:

"I've lost $4 million, 3 years of work, and other people's money. I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me. The amount of money I was making was ludicrous, could take out my folks and even extended family to nice dinners and stuff. Was planning to get a nice apartment and car or take my parents on a holiday, but now it's all gone."

Many of the investors were friends and family. I have not attached the relevant link to Reddit because much of the language is crude.

I'll leave it to Michael Lewis to write the XIV book and explain backwardation, gamma and contango, given he will have about 300 pages. Then go watch the movie.

It's not investing. Volatility trading and the need to cover leveraged risk on XIV and other products probably accelerated the overall market decline. This activity infiltrates mainstream stocks and induces investors to panic in response to headlines and fear. Forces such as these and high frequency trading (where computers automatically issue orders and now comprise about 60% of US equity trading) can have a pervasive impact on everyone's portfolio. The consequences appear to have been contained this time, and despite the screaming headlines, the US share market is ahead in 2018 to date.

This week, we start with three leading Australian fund managers. Roger Montgomeryand Paul Moore explain how they are reacting to last week's market fall, while Jack Graydelves into the threat that Artificial Intelligence (AI) brings to the wealth management industry. Then global chief economist Joe Davis says Bitcoin is a poor investment (it might go to zero) but has potential as a cryptocurrency.

Infrastructure funds have moved well beyond being considered as 'alternatives' and into mainstream portfolios, and Ofer Karliner makes the case for listed over unlisted assets. Pauline Vamos argues that portfolio management is not the same skill as asset class management, and we look at how Australian superannuation differs from global.

This week's Sponsor White Paper from nabtrade describes an alternative way to borrow to invest in shares that removes the risk of margin calls.

Graham Hand, Managing Editor

 

Edition 240 | 16 Feb 2018 | Editorial | Newsletter

 


 

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