“But you tell me over and over and over again my friend,
Ah, you don’t believe we’re on the eve of destruction.”

            Barry McGuire, singer and songwriter

We suspect commodity traders like to use the word “contango” in conversation whenever they can. Can’t blame them really. Not only does the word sound kinda’ cool — kən táng gō — ordinary, non-futures type folks have absolutely no idea what it means. Those with a Series 3, on the other hand, are less impressed. They know the word simply refers to when the futures price of a commodity is above its expected spot price. A normal market, in other words.

“This is the volatility event that we’ve been waiting for. A lot of people have become complacent.”

Commodity traders try to profit on the contango situation in flat markets by shorting (selling) near-term futures on indexes, rolling the positions forward as the contracts expire, and keeping the proceeds Utilizing the strategy, more than a few in the pits have made a ton of money over the last few years shorting one of the flattest and calmest indexes in history — the CBOE Volatility Index, or VIX. The so-called “short-Vol” trade has, in fact, been easily profitable across this bull market. Until Monday, the S&P 500 enjoyed 404 consecutive trading days without a 5% correction, the longest such streak since September 1959.

“Money kept pouring into the ETN, but it’s a dangerous product that most people didn’t understand.”

We shouldn’t be surprised, then, that Wall Street jumped all over the chance to deliver a complex, impossible-to-understand short-Vol product to ordinary, non-futures type folks. With the introduction of the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, symbol XIV, Credit Suisse did indeed make it possible for retail investors to trade volatility alongside the most sophisticated hedge funds in the world. Ignited by a 46% compound annual return from its inception to two weeks ago, assets in the note blew up to $2 billion.

“Two years of huge gains of as much as 800% in these products have turned to catastrophic and even total losses in just two weeks.”

But the product was built to contain the seeds of its own destruction. By prospectus, in the event of very sharp spikes in volatility – the very kind we’ve experienced recently — Credit Suisse reserved the right to liquidate the note to avoid being caught on its own hook. Which it did. As it happened, Monday’s record rise in the VIX index created a feedback loop in the futures market that prompted the bank to hedge itself in after-hours trading to keep the note’s value above zero. That action drove up the index and caused a permanent loss in the note. XIV was doomed to die.

“I watched it sink, sink, sink after hours.”

Credit Suisse says that XIV’s last day of trading will be later this month. A reminder that when it comes to investing, there’s no such thing as an “easy money” trade.

What the pundits have been saying…

“At the worst times to buy in the last 30 years, the stock market has been the best generator of wealth of any asset class.”

  • Paul Hickey, co-founder Bespoke Investment Group

What the equity markets have been doing…

INDEX Friday’s Close Two-Week Point Change Year-to-Date Change
DJIA 24,190.90 -(2425.81) -(2.14)%
S&P 500 2,619.55 -(253.32) -(2.02)%
NASDAQ   6,874.49 -(631.28) -(0.42)%
Russell 2000   1,483.12 -(124.39) -(3.41)%

 

What the fixed income markets have been doing…

FIXED INCOME Period Change YTD 12 Months Yield
U.S. Treasuries
+0.2%
-(1.9)% -0(.2)% 2.9%
U.S. Investment Grade +0.2% -(2.3)% +4.1% 3.6%
U.S. High Yield +0.8% +1.3% +4.1% 6.4%
U.S. Municipals +0.1% -(1.4)% +2.9% 2.6%
Non-U.S. Developed NC 1.5% 10.6% 0.9%

 

What the numbers have been saying…

  • $10 billion

The approximate amount BlackRock is looking to raise that it would use to acquire stakes in companies, replicating the approach of Warren Buffett.

What Fund Architects has been doing…

Concerns about rising inflation and interest rates coupled with an equity sell-off the likes of which we haven’t seen in years, has brought anxiety and uncertainty quickly back into the financial markets.

To start the month, we made several changes to the Fund Architect Portfolios consistent with our Multi-Factor Ranking System. In times like these, we’re glad to have a system in place that takes the emotion out of investing and help us navigate fast-moving markets.

Equity Rankings: 

Looking back over the past several months, several sectors of the global equity market have managed to hold on to their gains. When evaluating risk-adjusted returns, it’s not surprising the MFRS specifically identified two of those sectors — Global Consumer Discretionary stocks (a position we have held for several months) and U.S. Large Cap stocks – as positions for February.

If the recent sell-off in stocks continues, this dynamic can change quickly. If so, our system would likely begin adding cash, and potentially U.S. Treasuries, in attempt to reduce downside risk.

Fixed Income Rankings:
Despite all the action in equities, the larger story might be what’s happening in fixed income. Typically, a sharp sell-off in stocks would cause investors to flee to safety in U.S. Treasuries. So far, that has not been the case. It may be that the increase in interest rates investors have been speculating about is upon us.

In this environment, the MFRS indicates that Senior Floating Rate bonds, which are not sensitive to moves in interest rates, and Emerging Market Local Debt are the most favorable sectors for February. Each of these positions should hold up nicely if interest rates continue to rise.

Tactical Unconstrained Growth Changes:

Before the close of the market on Monday, the system saw enough weakness in the trends to add fixed income positions, specifically Senior Floating Rate bonds and Emerging Market Local Debt. As the index continued to deteriorate Thursday, the system made a more profound shift to fixed income, reducing the exposure to just 30%. The Portfolio, which evaluates the market on a daily basis, can move up to 100% bonds and cash as necessary.

Our interpretation of the events is we are still in a bull market but it is not as strong as before. Being invested is still important but not as likely to reward the more aggressive all-in position.

Our Thoughts
Our research has shown that emotionally selling into market corrections is seldom a good idea. Instead, we prefer to rely on the systems we have in place for reducing downside risk and adding cash where necessary.

If you feel good about the economy and corporate earnings, now might be a great time to buy into the Fund Architect strategies. Too often we chase its performance and flee its losses, when the opposite strategy is the winning approach.

What people have been saying…

“Us little guys working our butts off, we can’t get ahead. This (Bitcoin) is a once-in-a-lifetime opportunity to change my life.”

  • 35-year old Kentucky resident Cedric Knight

 


The views in this commentary are those of Fund Architects. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Fund Architects or any other investment professional.  The information contained within this commentary should not be the sole determining factor for making investment decisions. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Fund Architects. Information pertaining to Fund Architects advisory operations, services, and fees is set forth in Fund Architect current disclosure statement, a copy of which is available upon request. Fund Architects, LLC is an SEC Registered Investment Advisory Firm.

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