A few quick points here:

1.  I’m not as excited as I once was to post something about me on TV or video.

2.  I could say it’s simply lost its appeal but frankly I feel like whatever I say is surely going to be irrelevant by the next day.

3.  If you’re reading this post and today’s date is past July 16th, 2008, the video I refer to below is no longer available for viewing.  Sucks to be you cause you would have made a mint no matter what I said in point 2 above.  I know you trade on what you just heard from the Boo-Yaa guy on CNBC.  You think I don’t know?  Joke stops here but when you consider the amount of trading software commercials on that channel, you have to stop and wonder.

So anyway I was invited to speak on BNN on Wednesday.  BNN’s our version of CNBC in the great white north and BNN stands for “Business News Network” … yeah … I know … “Business News Network” … classic.  Don’t know why but for some reason I didn’t think about posting it until now.  Well, to be perfectly honest, for anyone with even the most basic self-education on VIX, there will be little new in this clip (after the short ad, scroll forward to just past the 29 minute mark and I’m on for about 7 minutes).  So again, if you’re reading this post a few days after I’ve posted it, you’re really not missing much from the video.

Funny that BNN called me on Tuesday to talk about VIX but due to a busy schedule I couldn’t make it that day … luckily we were both good for the next day. Tuesday’s close for VIX was somewhere around 23, a low for the past few weeks.  And they wanted to know why it wasn’t up over 30 given the market declines in those same past few weeks.

Bottom line: Should VIX be somewhere closer to 30?  Probably.  But being down where it was on Tuesday/Wednesday and given how volatile VIX is (volatility of volatility?!), well geez Louise, where are we now?  Here’s the one week chart:

So VIX came pretty darn close to 30 and if it does in the next day or two, does that mean all’s well with the planet again?  Come on … rules of thumb rarely apply and if there’s one place they basically never apply, it’s in VIX land.  Positive or negative correlations (like the kind I mention in the clip) exist for many relationships but can’t be construed as solid rules of thumb that necessarily can be relied on with a great level of confidence.  If you want to trade on generalizations, that’s fine but when things don’t go as expected (i.e. when you switch from paper trading to real trading), investors shouldn’t be surprised when things go astray.  That’s the beauty of life and the real art and science of trial and error.

Makes me think about middle school algebra when we first were introduced to variables.  Like “VIP”, VIX should mean “Very Important X” or variable.  It’s important, VIX is, because it can give clues to other important things just like the unknown variable in high school math.  But it’s not much later in our young academic careers when we realize that sometimes we can’t solve for X.  I don’t know about you, but a lot of the math courses I took didn’t end with X=3.  It was more like an equation where X equals some formula.  And that was even before calculus and statistics.

Thus, you have to wonder if VIX as a trading instrument is something for the masses.  Perhaps it’s best to be used as a signal for trading SPY or its inverse ETFs (or S&P futures or some other derivation of this strategy).  Trading VIX, whether via existing options or futures, or perhaps one day by way of an ETF, could be an area of exploration for hedge funds, day traders and various short-term active managers.  But with all the rules of thumb I hear and [false] expectations that “VIX should be at whatever”, if it were really that easy, why don’t we have an actively managed fund (mutual fund or hedge fund) that focuses entirely on trading the VIX?  Maybe there is one and if so please let me know.  I’d be interested in seeing its performance record.

Today, I had a last minute invitation to speak on Canada’s Business News Network … that’s not a description, that’s its actual name. The channel was formerly known as “Report on Business Television” so you’ll have to decide if their name change was an improvement or not. The six and a half minute clip will be available for viewing online here until sometime late Monday evening of next week (when you click on this link I’ve provided, a small window with a built-in media player should pop open). If this doesn’t work, then go here and scroll down to the 4:40pm “After Hours” program. Hopefully, I will be able to have the clip viewed directly here on this blog at some point.

The opening shot of me appears to be my poker face or I’m about to enter the octagon for combat or it’s the once-a-month event when I screw up WordPress and lose a big chunk of my blog posting. Either way, it’s my “death stare” and I can only imagine that I felt pretty lousy running from my car to the building entrance of the studio in what has to be Toronto’s heaviest rain storm so far this year.

Anyway, the discussion was on market volatility but unfortunately the focus was almost entirely on VIX. I say “unfortunately” only because VIX can be (well, it is) a dry subject due to its rather technical nature. Despite being on the channel several times before, you’ll note that the topic of VIX was not quite enough to get me really loosened up until just a tiny bit near the end.

Well, here are two charts which I discuss during the interview:

3 Year VIX Chart

17.5 Year VIX Chart

I was hoping to get into a discussion on emerging markets, gold and oil markets, and a broader geopolitical debate. But at the end of the day, VIX is a tool worth considering for the defensively oriented investor so there’s merit in its discussion. Along with outright shorting and inverse ETFs, there’s not much out there in terms of true diversifiers/stabilizers available in this high correlation world.

On the other hand, I have actually noticed lately that a lot of hedge funds (fund-of-funds, multi-strategy funds and even some single strategy funds) have had better than decent performance in 2007 YTD. Could it be a result of the VIX spike up since late February? I’m sure it’s more than that but this good performance comes after a fairly long period of so-so returns.

On a separate note, after my interview, I had dinner with one of the ProShares directors who was up here in conjunction with Horizon BetaPro’s launch of their new Canadian energy sector index levered and inverse ETFs. This follows up BetaPro’s launch last week of similar long and short exposure ETFs for the Canadian financial sector.

Based on this BetaPro press release from April, it’s safe to say that we’ll be seeing the gold sector ETFs sometime soon as well.

For review, this is BetaPro’s lineup as of today:

Horizons BetaPro S&P/TSX 60 Bull Plus ETF - HXU
Horizons BetaPro S&P/TSX 60 Bear Plus ETF - HXD
Horizons BetaPro S&P/TSX Capped Financials Bull Plus ETF - HFU
Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF - HFD
Horizons BetaPro S&P/TSX Capped Energy Bull Plus ETF - HEU
Horizons BetaPro S&P/TSX Capped Energy Bear Plus ETF - HED

The Canadian ETF marketplace has basically doubled in a very short time especially due to the recent product development efforts at both BetaPro and Claymore. Unlike in the US, we don’t have as robust - some may say saturated - ETF marketplace here in Canada. Frankly, we don’t have the broad acceptance of ETFs here like there exists in the US so there is some balance there. I would guess by looking at reports, such as those from Deb Fuhr at Morgan Stanley, that all other markets outside of the US also have a rather small but growing ETF industry and that is likely where we’ll see significant growth as the ProShares, PowerShares, WisdomTree and other smaller participants do the same as BGI, SSGA and Vanguard with their already established global expansions.

I won’t get into the discussions I had with the gentleman from ProShares except for the fact that I asked the question that I think many want to have answered: When do we get the international exposures?

I’ll just leave you with a “let’s wait and see”. Let me be blunt as usual … I’d kind of like to see them, specifically inverse exposures for EAFE and emerging markets available before the end of the summer. Certainly before the end of the year.

Oh, and one last thing to consider for those of you who want to get some inverse exposure to emerging markets. I don’t know if that’s the right call (bearish on emerging markets) but considering the strong run up in China, central/eastern Europe and basically all subgroups in the developing world, it’s worth making preparations. But what to do when there’s no inverse ETF and shorting EEM or VWO is the only reasonable alternative? I suggested to my dinner partner from ProShares that the BetaPro S&P/TSX 60 Bear Plus Fund might be a good choice especially considering the relatively high correlation between the Canadian equity market (TSX 60) and a broad emerging market ETF like EEM. I would only guess that the new inverse energy sector ETF from BetaPro would be an even better proxy for a short EEM strategy. There’s not enough historical ETF data but your friendly neighborhood Bloomberg terminal, Thomson Datastream or similar data source should provide you with data for the underlying index as the evidence you need.

It’s a tough, high correlation world. But perhaps there are ways like this to use high correlations to your advantage. The problem is correlations change in time. I’d much rather have the inverse ETF.

Recent market action in the US has made me think of what was going on about one year ago. Here’s the 2-year chart of the S&P 500:

A lot of market participants were prepared for what happened in May and June of last year. We weren’t the only ones with put options in play at that time. The run up from October plus a string of key indicators seemed to make a clear case for protection. In highsight, this graph above seems to make the drop in the first quarter of this year something even more foreseeable. Take a look at that (basically) straight line up from mid July to late February. If only life were that certain … well, an uneventful life isn’t great either. Whether it was the Chinese market’s sell off or any of a few dozen other reasons, that was a market that needed to let off some steam.

I have commented on VIX many times in the past. On the left margin of this page you can click on the “VIX/Volatility” link at the bottom of the categories list to find other postings that also refer to VIX. Here’s the 2-year chart of the S&P 500 with VIX overlaid:

And VIX in isolation, again for the past 2 years:

We’re not back to the historical lows of 10 but don’t let this graph fool you. 14 is not the historical average. Here’s the longer term chart from Yahoo Finance:

In this seventeen and a half year chart, 20 looks more like the longer term average. Note that when the markets fell (and fell hard) in late February, VIX spiked up to just under 20. It’s an understatement to say that we’re in a low vol environment.

Total speculation here but a pattern nonetheless: Note how VIX seems to have a longer term trend bringing it from the plus-20 range to the 10-15 range, like it did from 1990 to 1995. Likewise on the upside, VIX took a few years to go from the 10-15 range (1995) back up above the plus-20 range (1997-98). The downside trend from early 2003 to 2005 is another example. There’s no denying that there is significant “volatility of volatility” like we’ve seen from 1998-2002 and from early 2005 to now. These would seem to look like periods of a “sideways” trends on this longer term chart. The question now is if an upward movement of VIX would again happen in a 2-3 year period taking it from the 10-15 range back up to range in the plus-20s. My guess is it’s just a matter of time before VIX makes that climb up and I think it will be sooner rather than later. This is actually an area where I have been reading up on and if you search online, there are a surprising number of market participants and academics who discuss the longer-term views/forecasts of VIX.

Now, the 2nd chart above shows that in the shorter term, spikes in VIX coincide with sharp drops in the broader US market. However, the longer term chart above does not have the same pattern. Here’s the same long-term chart with the S&P 500 overlaid:

Note that I had to switch from a log-based vertical axis to a linear based axis to make the chart more easy to read. The key here is that in the shorter term, VIX and the S&P 500 can (but will not always) move in opposite directions. They move in opposite directions in times of extreme market movement. However, in the longer term, for example during the bull market of the late 1990’s, we can see that VIX and the S&P 500 can move in tandem. It’s all about the implicit volatility as measured based on prices of S&P option contracts but I won’t go into the math of Black-Scholes.

The follow up question then is how do you feel about this chart? S&P 500 (and just about every indicator for just about every asset class) is near or at historical highs. VIX is close to historical lows. The rubber band is being pulled tighter and reversion to the mean is providing some significant pull.

Let me be blunt: The S&P 500 is now somewhere above 1500 where it hasn’t been since September 2000. I see it’s closed today just under 1510 so it’s roughly 18 points short of its record close of 1527.50 back in March 2000. So another 1% rise ought to do it. Being up roughly 6.5% year-to-date, another 1% seems easy.

In addition, I’ve seen A LOT of commentary on this online but I’ll add it here anyway: The S&P 500 has gone up in 23 of the past 26 trading days — the longest such streak since 1944. Well, if you add today, it’s now 24 of 27 days. A hockey team with 24 wins in the past 27 games would be considered “on fire”. A boxer with a 24-3 record would likely be the title holder. But this ain’t no sport. 24 ups in the past 27 days should bring a cautionary “spidey sense” to investors.

[UPDATE/CORRECTION: According to this article from CNNMoney.com, the run of 24 ups in the past 27 days for the Dow 30 ties a record from 1927. I think this stat will be repeated SO many times in the next few days … and imagine if Tuesday is another up day!

Just a string of facts. A possible time for tactical measures? A boy scout would call it preparedness. I think that options should already be in play … if you’ve been invested in the S&P 500, then you have about a 6.3% return since the end of March. Some of that return could finance some put options for even a partial hedge.

So, next question (I think we’re up to number 3 now) is whether now is a good time, especially with volatility near historical lows, to buy some portfolio insurance?

The follow up to that is whether you want to go even further and set triggers for shorting futures or purchasing inverse ETFs. I’m still thinking tactically here. You have to do the same with your own philosophy of asset allocation. Are you more long-term oriented, thus focused on strategic asset allocation, or do you have a shorter-term perspective? If the latter, then you’re already thinking about tactical measures, if not implemented already.

Why not a few more charts? Everything below is charts for ProShares’ inverse ETFs showing performance since their respective inception date. Here’s the inverse and double-inverse for the QQQ:

Here’s the inverse and double-inverse for the Dow 30:

Here’s the inverse and double-inverse for the S&P 500:

Here’s the inverse and double-inverse for the S&P Mid Cap 400:

Here’s the inverse and double-inverse for the S&P Small Cap 600:

Here’s the inverse and double-inverse for the Russell 2000:

We can see from the first four charts that it’s been tough to go against the market. The small cap market, through either the S&P 600 or the Russell 2000 have only been available in an inverse ETF for a short time and there seems to have been little interest in them as shown by the trading volumes for the bottom two charts. My feeling is that all of these inverse ETFs, including the small cap exposures will begin to see increased trading volumes in the coming weeks. There is already a significant level of short interest according to communications from the sell side and we know that fund flows are coming out of equity funds and into bond funds. So, perhaps like about one year ago, investors are preparing for the storm.

This posting is not a recommendation for any of these inverse ETFs. For those of you looking to protect/hedge existing positions, only you know what you hold whether it be mega caps (you’re likely looking at DOG or DXD) or a tech heavy portfolio (consider PSQ/QID). Also note that ProShares also has short exposures to value and growth tilted indices as well eleven sectors. For these cases, all are for domestic indices and all have 200% short exposure. For those of you looking for something in the ETF space beyond these such as international exposures, you’ll have to consider shorting ETFs. I am absolute amazed at how long it’s taking other ETF participants (Rydex) to get into the inverse ETF space. I see a parallel here to the GLD/IAU situation in gold ETFs. If Rydex doesn’t get in here soon, they’ll “pull an IAU”.

Final note: If we’re basically talking about market timing here and all of the above seems pointless, you can simply take some profits and thereby build a cash position to buffer downside volatility!

Risk Magazine isn’t what I would consider standard reading in the financial services industry, as the last few sections of each monthly publication breaks out the math. I’m talking about equations that have few numbers and a ton of greek letters. Despite this, there is the occasional article that covers relevant industry developments for the non-quant. There is one article that discusses the recent push of products aiming to replicate hedge fund return distributions.Both Alpha Male at the blog, All About Alpha, and myself have commented on this topic and the work of Harry Kat, Andrew Lo, Bill Fung and Lars Jaeger (among others). But I find this article I find to be unique as it introduces the new term of “portable beta”. I’ve actually heard this term applied before within the context of the portable alpha framework. Basically, if you can transport an alpha engine (long-short emerging market equity, for example) on top of some beta component (S&P 500 index), it’s both the alpha AND the beta that can be transported and mixed in countless ways.

But in this case, we’re looking at research that has resulted in the application of beta in some unique and somewhat complicated fashion (combination of longs and shorts to various degrees in any number of different futures markets) in the attempt to replicate a certain hedge fund style/strategy’s performance characteristics.

There’s no argument here … the providers of these new products/services agree that what they are providing is beta, not alpha. And this is of little surprise when you see how correlated various hedge fund indices have been relative to standard benchmarks such as the S&P 500. If many (not all) hedge funds have high correlations with the broad capital markets, there’s little choice but to:

1. Be highly selective of the hedge funds one chooses in the hopes of having them deliver true alpha (at a cost).
2. Focus on gaining the beta exposures related to hedge fund investing at the lowest cost possible.
3. Do nothing and hope that the relatively high beta exposure that seems to have spread from the mutual fund industry to the hedge funds is a trend that reverses as the current bull market potentially/eventually comes to an end.

According to Steve Umlauf of Merrill Lynch:

“We do think there is alpha available out there through good fund managers. And if you can identify it and get access to it then it’s worth paying for. But if it’s just beta you’re getting, then it should be sold like an index fund - that is, in a liquid, low-cost, transparent format.”

Sounds pretty close to an indictment of the hedge fund industry from one of the big banks. Like other banks, ML must have hedge fund clients, in addition to their own alternative investment programs, so those words must have been massaged by more than a few people internally.. As an academic, Harry Kat of the Cass Business School in London has more freedom to speak his mind which he does here:

“Based on our research, we estimate that in 70-80% of the cases, a hedge fund manager’s contribution to the after-fee bottom line is zero or negative. Investors basically allow the manager to make a very good living using their money without getting anything in return. Unless one is genuinely attracted to this form of charity, in these cases it is worth replacing the manager in question by a synthetic fund.”

Harry has his own software program to go up against the big industry names so you can understand the direction he’s coming from. But like AlphaSwiss and Partners Group, you really have to wonder if the numbers used for all of these products has more of a bias based on recent data, specifically the bull market since 2002. The real question is how will these replication programs behave versus the comparable hedge fund strategies they aim to mimic?

If we are in the middle of a correction more serious than that experienced last summer, I’m afraid we will likely separate the men from the boys, so to speak. I doubt many funds with an absolute return mandate will do well. I’m not saying that there won’t be winners, I’m just betting that the vast majority will be losers. Just remember, there are a lot of hedge fund managers out there and they clearly all can’t be winners. The likely scenario will be a relatively small number of big winners with a relatively large number of “not so terrible” losers. Just my opinion.

This still leaves room for manager selection, but that sport is obviously getting tougher every day. Thus, this new area of hedge fund replication or portable beta should get broad acceptance if things continue as they’ve been. In reality, this development is just the transfer of indexing strategies to the hedge fund space but without it being the investable hedge fund index programs that were attempted a few years back with not much success. According to the Risk Magazine article, Lars Jaeger of Partners Group suggests “it is only a matter of time before more big investment banks and some of the index companies launch their own offerings in this market. Indeed, some participants predict portable beta could make up 40% of total hedge fund assets in just a few years’ time.”

It seems that anything (even hedge funds) that is considered alpha can and will be commoditized to beta in time as inefficiency becomes efficiency due to competitive forces. And this comment further confirms my thought that index providers and ETF manufacturers are catering more to the active investment crowd rather than the traditional passive investor. Index providers don’t need to promote an index for pensions to benchmark certain asset classes to … it’s been done to death and institutions are already there and may be considering moving away from that and to a portable alpha/liability driven investment framework. My guess is that the index providers are spending considerable resources in joint work with ETF manufacturers and other non-traditional work, including portable beta. They may not be working jointly on a hedge fund ETF … I’m just saying that index providers have focused a lot of their attention on ETF related business in recent years.

Getting back to the main topic, some questions that both the index providers and interested investors should consider regarding hedge fund replication strategies: Will they adequately replicate the underlying hedge fund strategies? Precision will be based on what comparison? If a particular hedge fund strategy (or strategies) does poorly in a bear market environment, will the replication strategy behave properly i.e. just as badly in that scenario? On the other hand, if replication strategies perform well in a continued bull market, will it build a strong following as investors dump high cost hedge funds that provide more beta and alpha in a rising market?

In any case, it’s getting tougher to be a hedge fund manager. It will be very interesting to see the performance numbers for February and even more interesting to see what happens in March.

Aside: VIX is roughly at 19. Looking at the short-term chart, you’d think that it’s high and it is since it’s spent many recent months closer to 10:

But if you look at the longer term chart you see that it’s actually fairly close to what would be considered it historical norm.

Like this past summer, it will be of little surprise to see asset class correlations spike up with the rise of VIX. Bonds and cash will provide some buffer but generally, exposure to beta of any sort will be painful if momentum builds. As I write this, the US equity markets are moving down but nothing like overseas markets. But you can feel the tension as investors consider the plug to be pulled. As VIX climbs higher, we move more towards an active investor’s environment. If you’re paying someone to make profitable decisions, you’ll want to make sure they’re not on vacation right now. If you are a long-term oriented investor, this is one of those times when your faith in long-term thinking will be tested. Take another look at that long-term VIX chart. We’ve recently seen historical lows with VIX spending some time below 10. Historical highs well above 40 haven’t been seen since the bottom of the bear market. Despite VIX’s recent climb, it still has the ability to move much higher.

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.

OK, we’re well into earnings season with not much in terms of surprises. Financials are showing generally good strength, but there’s really not much to focus on. At least earnings should be the focus. Obviously, it really isn’t. So what’s then is the focus?  Geopolitical tensions related to:

1. War: Possible regional war involving Israel, Lebanon, Syria, Iran … there’s some talk out there about this being the start of a world war although that’s quite a big jump … however, think about what started WW1 and WW2, regional wars in certain parts of Europe

2. Oil supply disruption: Nigerian pipelines again

3. North Korea: No one foresees a war there because China (business is good), Japan (too much to lose) and Korea (still growing well) all are too close to eachother to risk going nuclear. NK might not be there in terms of launch capabilities, but who knows if their nukes can be dirty bombs?

4. India bombings: More bad news for emerging markets who really got hurt in the past few months

5. Cold relations between the US and Russia. Bush and Putin seemed to talk nice in the G8 meeting but the trend does not look like they’re getting closer together. It’s in the US’ interest to figure out something … they have to with oil prices at all time highs and Russia pushing its agenda in eastern Europe (as well as its ally in China … think war games exercises held jointly by both armies last year).

6. With all of the above, it’s almost like Iraq isn’t an issue but you can’t say that with casualties still occurring on all sides and US dollars continually being spent there.

And so where are the markets now? About where they were at the market low (June 13/14). Nasdaq is actually quite a bit lower.

I was hoping for markets do drive up to new highs and then drop down to push past the lows of June 14th. It’s happening sooner than I thought. No one could have predicted this since it’s mainly due to the action in Israel/Lebanon. With oil very close to 80 (some talk of 90), can the US economy keep humming along. Numbers from China continue to amaze me. They’re traveling around Africa and other corners of the world buying up expensive oil (among other commodities), but they’re still moving in high gear.

What’s the chain reaction? Inflation numbers up globally. Central banks continue to tighten globally. Liquidity dries up globally. Hunkering down (less spent on travel/leisure, reduced discretionary spending by consumers, business and governments, etc.) leads to slower economy continuing the concerns of slower and possibly even negative growth. Stagflation?

Why did the 10 year blip downwards on various occasions last week while the short side of the curve moved up a bit? The very short end is going to go up if the Fed (in addition to other central banks) continue to raise rates. Inverted curve not discussed as much these days but it could be a sign that agrees with my stagflation argument above.

I saw online that Bill Gross is talking about possible rate cuts by early next year. More fears of negative growth over inflation.

A very confusing time. In confusion, you must do the following:

1. Remember, keep high cash balances to prepare for shopping when prices are really depressed.

2. Watch the VIX (market volatility index). Buy at-the-money VIX calls when VIX is anywhere close to 12.

3. Keep the portfolio diversified. Keep minimal positions in stocks, bonds, cash and alternatives (gold, REITs, hedge funds, etc.). Despite the fact that correlations spike to 1, thus losing its benefit, its still better than putting all your eggs in one basket. If there is a bias to anything, it should be cash, then maybe gold.

4. Stock up on commodities. I stilll like gold. I still like energy. The various geopolitical events causing greater uncertainty works well for these (more the commodity itself than the stocks). However, in the case of both gold and energy, I strongly believe in owning both the commodity (futures if possible) as well as the stocks in that sector (ETFs if possible or direct stock selection).

The equity markets have basically had a straight line up since early 2003 through April 2006. It was time that the markets gave back something. The declines of May/June brought markets back to where they were near the beginning of the year (S&P 500 dropped to prices last seen in early Nov 05). So markets have basically given back six months of gains. But they were big gains (9.0% from Nov/Dec 05 to highs of 2006). I’m not certain if the “give-back” was enough. My view is that markets may retest the highs but won’t go far beyond if they do. My greater concern is for the market to strongly test the lows of mid June before the end of this year. By how much, no one can know.

Some say fundamentals look good now, better than they’ve been in a long while. With all the stimulus on the market now, the time to buy is when fundamentals look even better and there is greater clarity on many subjects, both macroeconomic and geopolitical. It may be too late to sell but investors should hold minimal amounts of all major asset classes anyway, assuming they have long term objectives. Still too early to buy. Now’s the time to accumulate cash where possible.

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.

Whether you believe that the correction is nearly over, or that we’re about halfway through (or even more bearish than that), hopefully you have built some cash reserves and hopefully this was done prior to the May selloff. If so, it’s time to build a shopping list. Here are some positions to consider:1) First, a look at an area that has been hurt badly and is probably the best area for constructive debate: emerging markets. The iShares emerging market ETF (EEM) has gone from a high of about 111.25 to 89.80 (always using yesterday’s close), down about 19.1%. Vanguard Emerging Markets VIPERs (VWO) has gone from a high of about 76.51 to 61.63, down about 19.4%.

Coincidentally, according to the charts, we’re right back where we were at the beginning of 2006. Roughly 0% return YTD. Now, there’s been a lot of talk about potential slowing of trade in the EM region as a consequence to bearish views on the US economy and rightly so, but what percentage of future EM trade will be dependent on North America? Separately, looking at a long-term chart of EEM/VWO, you have to think that some steam had to be released from the pressure cooker.

Also important to note are the big holdings in EEM/VWO like Samsung Electronics. It is the largest holding in both of these ETFs with roughly 5% weighting in each. That’s actually not bad compared to Samsung’s roughly 20% weight in the South Korean ETF (EWY). South Korea is down just over 16% since its peak in early May and so it isn’t surprising that EEM/VWO are both down similar amounts considering that there are some large holdings from this one country (Of note, South Korea raised rates unexpectedly today which could further the bleeding … in fact South Korea was down 3.5% Thursday with the rest of east Asia performing similarly).

Of course, there are significant holdings in other EM regions like Latin America which have been even worse. The Latin America ETF (ILF) is down about 22.6% since its peak on May 10th. Again coincidentally, ILF is very close to where it was at the beginning of the year. The numbers may sound scary, but I think there’s plenty of room for prices to go down further. How far and for how long no one can know. I haven’t even commented on views regarding the BRIC countries and news of possible upcoming BRIC ETFs. But as a long-term investor, I think it would be prudent to at least have a 5-10% allocation to EM equities such as EEM or VWO. The trick will be avoiding major drawdowns like we’ve seen in the past month.

2. Bond ETFs. Inflation and the debate if there is or isn’t any, or if there will be or won’t be any in the near future has almost made my mind numb on the subject. It seems like it’s an unending debate on CNBC but luckily the World Cup will occupy a lot of my upcoming screen time. We’re still not fully in on our bond exposures (relatively overweight cash in lieu of bond ETFs). We’ve held certain index bond mutual funds and a few bond ETFs (including TIP) but are currently working on this area of the shopping list. I’d like to see a US domiciled international bond ETF. Let me know if there is one. For now, I’m watching TLT. I’ll update our progress on this area in a later entry.

3. Commodities. We’ve held all our commodity based ETFs during this market downturn as we have only about a 5% weight in materials (gold related ETFs) and energy (IGE, PBW). Of note to Canadian investors, we hold the TSX gold subindex ETF [XGD] and the TSX energy subindex ETF [XEG], both traded on the TSX.

We may rebalance these by topping up at some point but expect both gold and oil related ETFs do drive up sharply over the summer months. For those that have been tactically inclined and gotten out of these positions recently, I can only bet that you are contemplating new points of entry. But, like the EM positions from point #1, these are obviously volatile so from a risk budgeting framework, I would not consider putting more than 10-15% in the commodity complex.

We, up here in Canada, are not immune to the “home bias” phenomenon so have greater than global market cap weighted allocation to Canadian equities. Thus, since a broad Canadian ETF has nearly 50% allocation to materials/energy, an investor with a 10-15% allocation to the commodity complex plus a 20% allocation to Canadian equities may actually have close to a 25% commodity sensitive portfolio.

Thursday’s opening bell is about to go off. Despite some news from Iraq, the mood is not good at all after market action from Europe and Asia. A lot of uncertainty. Wouldn’t be surprised if VIX finally breaks above 20.

As mentioned in my previous (and first) entry, I actually started in the industry at a highly specialized hedge fund (separate managed futures and long-short equity mandates) although we never called ourselves a hedge fund. Now I am more focused on traditional long-only, no leverage, broad global asset allocation mandates.Weird, I know. Everyone else is dumping their mutual fund manager job to start up a hedge fund. Can’t blame them. Sure there’s the money. That’s a reward for being smart, good, lucky or some combination of this and more. However, the truth is that what any type-A personality in this industry wants is independence. What is a hedge fund but a mutual fund with lesser constraints?

Ask any manager what is more important: Being right or making money? I’m pretty sure they’ll say making money. But to make money, you better be right. As a mutual fund manager, you can be right but still perform poorly. In sharp down markets, without the ability to tactically allocate to cash or even short, it’s tough to protect the investor. Rather, it’s all about relative performance in that world, thus the argument that most mutual funds are “closet indexers”. For most readers, everything thus far is nothing new.

What concerns me is that we’ve just seen a very interesting month in May. Comments have been made that it’s the worst month for the S&P 500 in 22 years. To me, the price action of the S&P 500 is nothing like what’s happened earlier in Iceland, New Zealand and markets in the Gulf region. Can we expect more? Possibly, but my concern in particular is oriented towards the performance of active managers, specifically hedge funds. Big down returns in index funds especially for specific areas like emerging markets and commodities are fine. Hey, if you didn’t know these were volatile asset classes or that they had a nice long and fairly stable run up that past few years, welcome to class! But hedge funds should have made a killing this month. After at least two years of unspectacular returns (blame low VIX, low interest rates or whatever else you want) they must have been waiting for a month like this.

However, the word is out that hedge funds in general did not have a good month. I’ll wait to see what the various hedge fund index providers send out later in June for the May numbers, but this would be a great surprise to hedge fund investors. Or should it be? Hedge funds had very decent returns in the first quarter of 2006. VIX was still relatively low and there weren’t any big market events tossing things around. Basically, things were quite boring with decent broad market index returns.

Can we simply conclude that many hedge funds had substantial long positions in commodities, equities and other broad asset classes? That would be too simplistic an answer so I’ll ask it differently. After years of relatively poor returns, have many (or most) hedge funds exposed themselves to broad beta exposure due to the relative scarcity of alpha during the market run up from early 2003 to early 2006? The answer is yes.

Don’t get me wrong. I’m not anti hedge fund. But if hedge funds and “fund of funds” market themselves as “performers in good and bad markets” that implies market neutrality or specifically beta neutrality. There has been significant discussion, especially in the institutional world where costs for beta exposure matter, that hedge funds in general have had higher than expected beta exposures, and specifically to the S&P 500.

So, mutual fund managers said that they manage their funds well to outperform their target benchmark index but have in aggregate been more like index trackers. The question to ask is: Are hedge funds falling into the same trap?

My answer is no. I think that they’re doing what they have to do. Being right or making money? Well, I think they’ve realized that 2003-2006 was basically a desert for returns. Their quest for an oasis has led them to beta exposure. That’s part of being opportunistic. If their strategy (whatever it is whether some form of arbitrage or directional trading) has not worked as in the past due to the current market environment, what choice did they have? Again, they say that their job is to be “performers in good and bad markets” not just “performers in bad markets”.

The only question now is whether their beta or market exposures are so high that they their returns are highly correlated with market returns, especially on the down side. If this correction continues with hedge funds returns moving lock-step downwards, then there will have to be some serious rethinking of their value added by investors as well as some reflection by the hedge funds and “fund of funds” of their own philosophies and processes.