News today from the Associated Press about an early start to this year’s storm season. It’s a subtropical storm, not even a tropical storm never mind a hurricane, but with all the craziness in weather patterns in recent years, you can never be too cautious or prepared. On the investing side, this gives us (investors keen enough to read this blog!) some lead time before the official start of hurricane season which is June 1st.

First, some background reading on weather derivatives:

This article from Canadian Investment Review is from back in 2002 so you can see that weather derivatives are really not that new as an asset class. The article was written by Jason Wei, a professor of finance at the University of Toronto. This is a powerpoint presentation from Wei and Melanie Cao of York University. It’s even older but gives some deeper understanding of how the weather derivatives markets evolved to that time, the types of instruments available and the basic strategies for use.

One of the big problems cited from that time was the lack of investor interest and the resulting issue of liquidity. With hedge funds actively participating in the weather derivative markets especially over the past few years (along with re-insurance/catastrophe bonds due to the spike in extreme hurricane activity), this is not as big an issue. The purpose of these documents is simply to give an idea of where this quite esoteric area of investing came from. I mean, if you tell your friends that your recently established investment is dependent on the heat in Baltimore, you won’t get that funny look?

Now, let’s focus on where we are today. Here’s the link to the Chicago Mercantile Exchange’s weather derivatives website. In the opening paragraph near the top, I found the last sentence quite interesting:

This sector of hedging and risk management products represents today’s fastest growing derivative market.

Fastest growing derivative market. Well, I suppose the other broad areas of equities, interest rates, currencies, commodities and real estate have built well established markets in this space so weather derivatives, despite being around since 1999 (at least on the Merc), are still the new kids on the block. But perhaps it’s also the added focus from the press on the global warming issue and personalities like Al Gore that have moved environmental finance forward as part of a broader solution to what is clearly a massive problem.

Once you arrive here to this site, you’ll see a list of weather contracts, many of them related to temperature but some that I think are quite interesting like the ones for frost and snowfall. Here in Toronto, we’ve been experiencing summer-like weather for the past week and a half. We have no spring or fall here, just a long winter and about four months of summer. I exaggerate but unless you live up here, you just won’t get it. The idea of profiting over the cold months sounds appealing. The idea of profiting from times of heavy snowfall can somewhat compensate any northerner’s aching back after shoveling their driveway. A snowblower would make sense but I’ve just discussed the massive environmental problem, right?

But, of course the reality is that there are many industries who rely on these derivative instruments for serious hedging needs. Think of a utility whose electricity usage spikes up during a heat wave. And, of course, there are the hedge funds on the other side willing to take their bet. Again, one of the popular areas in this field is in hurricane futures which is one of the instruments listed on the CME website. According to this section of the website:

The CME Weather Product group has added CME Hurricane futures and options on five U.S. defined areas - Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. The underlying indexes will be calculated by Carvill, a leading independent reinsurance intermediary in specialty reinsurance that tracks and calculates hurricane activity. These contracts will begin trading March 12, 2007 for the 2007 hurricane season that begins June 1.

You would think that this type of recent product development would be getting a lot of press, but I just don’t see it. Good for me and my little blog but if this was an ETF? Sheeesh! There’d be coverage left-right-and-center. Probably most of it would talk about how the industry was yet again finding another thin slice of the market to exploit with an ETF product offering.

But hey, weather is an attractively uncorrelated asset class and I’ve discussed at length and in too many occasions about the fact that this investing world is troubled by highly correlated asset classes leading to synchronized, and due to the multiple compounded herd mentality, sharp down markets.

There’s a lot on the CME website and from the previously cited CME Weather Products main page, the tabs for Education and Resources should provide more than enough background before you begin to implement. Just don’t think that you’re ahead of the curve by exploring of actually entering into this market. Take a look at this chart showing, no surprise, another market with recent explosive growth:

This global liquidity thing … it’s really something. If there’s a market for something out there that isn’t getting a ton of attention and money, it’s a rarity. Domestic automobiles and not much else, I think. This chart cites its source but I found it from this good article from Financial Engineering News. The article is interesting as it gives a nice story as to who is interested in these instruments and why.

For me, someone interested in the asset allocation problem, I’m interested in understanding how plugging something like a weather derivative will affect the overall performance of a globally diversified asset allocation program. As someone also interested in underlying beta risks in multi-strategy and fund-of-hedge fund mandates, I’m keen on knowing if these instruments are useful ingredients in a recipe to provide the appropriate short overlay to offset unwanted long market exposures.

Many different reasons to consider these new products. For many who are simply fascinated by the strength of recent hurricane seasons, perhaps a visit to the National Hurricane Center website might provide evidence to entice them into the new hurricane futures market. To each their own, but I can’t stress enough the need for uncorrelated investments and this area is one of the few that requires investor attention.

We’ve seen the S&P 500 go up in a strong linear fashion since mid July. A bit extended perhaps? Here’s the 3 month chart:

  We’ve seen some fairly low values in VIX over the past few months as Here’s the 2 month chart for the VIX:

  Incredible to see a few days under $11. It’s been down at $11 before (even as low as $10) as seen in this 3-year chart:

  What’s interesting is the behavior of the S&P 500 relative to the VIX. Here is a chart showing the two:

  An obvious pattern shown clearly in the chart above is that the S&P 500 is climbing well when VIX is falling. This is usually over a 2-3 month period:

· May-June 2004

· mid August-early October 2004

· late October-Christmas 2004

· mid April-late July 2005

· mid October-Christmas 2005

· July-current 2006

If the current trend (upward S&P 500 and downward VIX) continues, then this would be a significantly larger and longer decline period of the VIX (going into 4 months). We’re currently just past the 3 month mark.

Looking at the 3rd chart above, $10 seems to be a fairly firm floor, although it seems like VIX doesn’t like staying down there. There’s almost a propensity for the VIX to bounce off $10-$11 and within a month reach $14-$15.

Bottom line: This looks like a good time to buy VIX call options. If the S&P futures look weak Wednesday morning, a quick entry may be in order … I started off this piece with the question if this rally may be a bit extended. Patient watchers may want to “wait and see” in the hopes of entering when VIX is closer to $11.

Given the market action, I’d like to continue on my focus on defensive measures (inverse ETFs, VIX, cash balances, etc.). Today, I received a notice from Business Wire regarding new options on some very interesting ETFs:

The Chicago Board Options Exchange today announced it will list options on the following five ETFs beginning today: First Trust IPOX-100 Index Fund (AMEX and CBOE ticker symbol FPX); iShares FTSE/Xinhua China Index Fund (NYSE and CBOE ticker symbol FXI); Market Vectors Gold Miners (AMEX and CBOE ticker symbol GDX); Powershares Wilderhill Clean Energy (AMEX and CBOE ticker symbol PBW); and Powershares Water Resources Portfolio (AMEX and CBOE ticker symbol PHO).

The Designated Primary Market Makers [DPM] for the options are as follows:

First Trust IPOX-100 Index Fund (FPX)
DPM: Jane Street Specialists

iShares FTSE/Xinhua China Index Fund (FXI)
DPM: Jane Street Specialists

Market Vectors Gold Miners (GDX)
DPM: Jane Street Specialists

Powershares Wilderhill Clean Energy (PBW)
DPM: Susquehanna Investment Group

Powershares Water Resources Portfolio (PHO)
DPM: Susquehanna Investment Group

For more information on new listings, visit the Trading Tools section of the CBOE website at: http://www.cboe.com/NewListings.

Frankly, I’m not a big fan on the first two of these ETFs. FPX is unique in concept but as an risk/asset allocator, it’s hard to see how this fits in the overall portfolio construction process.

For me, there are just so many better choices to play China than FXI. Although a big believer in ETFs, China has to be one area where an active manager has a more than decent shot of beating a comparable benchmark index. Also, the costs of FXI don’t justify what’s in the fund. I think that instead of an index ETF, China should be managed with a long-short equity strategy. Whether that’s actually possible (restrictions from Chinese securities regulators) is an obvious limitation but certainly there’s optimal solution somewhere in between.

Although late in arriving by just over two months, put options on GDX, PBW and PHO are certainly a good arrival for investors in these underlying positions.

Investors who use some sort of risk budgeting system to help in determining asset allocation constraints will be happy to see more options for ETFs that have historically shown large price volatility. The recent discussions on this site on the pros/cons of inverse funds, shorting and put options should allow more investors to essentially manage their portfolios in a very “hedge fund”-like manner.

Watching Tuesday’s launch of the space shuttle live on CNN got me thinking about risk management, since a lot of the commentary was about the threat of foam falling off the shuttle’s exterior, just as had been in the case during the Columbia disaster when the shuttle was destroyed upon re-entry from space.They also discussed other possible mishaps. The comment was made that at one point all the astronauts as well as technicians down on the ground were thinking the same thing: “Hope I didn’t forget something” or “Hope I don’t mess it up.” Though only discussed for a relatively short period of time, it was a rather uncomfortable tone for what was a very nice July 4 day in Cape Canaveral.

So, the question I have is what risk management process did NASA go through after Columbia? NASA is the home of the real “rocket scientist”. I recall from the movie Armageddon, one of the NASA guys trying to figure out how to save the world from a giant meteor’s impact was supposedly “the smartest guy in the world.” Really now? Well, if there’s a book on the subject, I’d be interested in reading it.

Should be good for investors to consider that “black swan event” (term from Nassim Taleb’s book Fooled By Randomness), how best to plan for it, and how to deal with it when it eventually happens.

Just a thought. Are there little things that can happen (consider something as insignificant as a piece of tile falling of the underbelly of the shuttle) that could cause so much trouble that it causes massive damage to an entire entity? That tile is clearly no longer considered insignificant. Of course there are many potential causes for the markets, and thus your portfolio, to have a serious disaster. There are numerous scenarios starting with countless initial events that could cause a cascading effect resulting in a major market meltdown.

Now, we really don’t have to consider a complete “total destruction situation” where a diversified portfolio falls to zero. However, we can all think of scenarios which lead to a 50% loss or more. I’m not sure that the actual number is important. I’m not even sure if the causes are important because, frankly, can we do anything about it? What is important is to remember that in times of complete distress in the markets, correlations spike close to 1. This means that the benefits of diversification fail investors when they’re needed the most. There’s a similarity where distress to a certain component of the shuttle may lead to its total destruction.

So what should be of high importance to investors is what can be done on relatively short notice to cushion the blow of a quick and major market downturn?

First, before trying to trade your way out of trouble, make sure the basics are in place: diversify your portfolio well with various uncorrelated and even negatively correlated positions. Strategic asset allocation is key including the importance at times for high safety positions (cash/gold). Diversification fails, but not often.

When it does fail, not everything fails completely. VIX options and futures are good examples of instruments which are very negatively correlated with general market trends, although truly effective as a short-term play. Broad market equity index derivatives (buying put options, shorting index futures) are a cheap and easy method. But with the recent inverse ETFs, there’s a choice for investors who are accustomed to holding only long positions in funds. These funds have been discussed numerous times before, but here’s the list again:

* Short QQQ ProShares (Amex: PSQ)
* Short S&P 500 ProShares (Amex: SH)
* Short Dow 30 ProShares (Amex: DOG)
* Short MidCap S&P 400 ProShares (Amex: MYY)

In all cases, when you start to consider these as potential positions, you have to switch from your “strategic asset allocation hat” to “tactical asset allocation”. It just doesn’t make sense holding these positions for very long unless you are in a serious decline like in 2000-2002 or those of the early and mid 70’s. On the other hand, all of these potential choices have a cost if you’re wrong about the direction of the market. Clearly that’s what hedging is all about.

You buy insurance for your home, car and body. Assuming you keep up your home, change your car’s oil and are disciplined about daily vitamins and exercise, doesn’t your diversified portfolio require insurance as well?

My argument is that it’s slightly different for a portfolio. I don’t think you need continued exposure to a hedged position (long put, inverse ETF position or otherwise) as you do with daily vitamins. But with TAA, it’s all about the timing. Yeah, it’s tough. But it’s not rocket science.