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An Early Look Back at 2018

2018 hasn't been a good year for volatility funds.

In February there was a feedback driven catastrophe in the implied volatility space. The details are less important than the result. A lot of volatility funds lost more than 30% in the month and one of the largest funds lost over 80% in a day.

The last few months have also been tricky. Equity markets have been more volatile than expected, but the bigger problems have been in the commodity space. In particular, crude oil and natural gas have been, to quote a very experienced trader, "****** unbelievably ****** insane! Like ****! Seriously dude. ****!". And you may have seen a sad youtube video where a hedge fund manager tearfully apologizes to his clients for losing all of their money due to the "rogue wave" in the natural gas market.

I'm not dancing on anyone's grave. I hate to see a business fail and I hate to see investors lose money. But there are also some important lessons here.

February emphasized …
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Mid-term Elections

Mid-term elections are not usually very memorable affairs. The voter turnout is much lower than for presidential elections (since 1960, voter turnout has averaged around 40% versus 60%). It seems likely that voter interest is atypically high this year, but that isn't the point of this post.

What I want to know is, "How do mid-terms affect volatility?" It is generally true that volatility declines after scheduled events like this. It has been shown to be true for presidential elections, but it also applies to crop reports, earnings announcements and big economic releases. My guess was that mid-terms also produce a similar effect. The average voter might not be interested, but volatility prices are set by the marginal volatility trader not the average voter.

Vix data only goes back to 1990. This isn't a particularly large sample, but it does cover some significant political issues including two gulf wars, the Lewinsky affair, a disputed election and the tea party forma…

Due Diligence as an Alpha Generator

“People, process and product”
-Marcus Lemonis, host of CNBC’s “The Profit”
In my last post I discussed some of the hazards of assigning numerical measures to hedge fund performance and suggested that keeping things simple might be the most robust approach. Here I’m going to write about evaluating the business side of a fund.
In his business turnaround TV show, Marcus Lemonis is fond of saying that he evaluates a business based on people, process and product; his “three p’s”. I’m going to use the same framework but add one more as well. I must list these in some order, but that doesn’t reflect any degree of importance.
Everything a fund does is because of the people running it. You are not investing in a fund. You are investing with people. It is important to know who the managers are, their backgrounds, their experiences, their levels of involvement and the amount, both professionally and financially, they have invested.Do they treat your money even more respectfully than they…

The Siren of Statistics

A siren was a mythological being who lured sailors with their enchanting music to shipwreck on the rocky coasts of their island. Their songs were almost impossible to resist. But more generally a “siren” is a bad thing that we are attracted to, either physically or psychologically.
For investors, an example of a siren’s song is simplicity. Many investors are prone to looking for just a few metrics to evaluate a fund or a strategy. This is a problem. It is a problem for me because my answers to reasonable sounding questions will be incomplete. “What is your Sharpe ratio?” sounds reasonable enough. But the answer on its own is close to meaningless without a much more detailed elaboration. What is the sampling error around the point estimate? How constant has it been across sub-periods? How distorted is it due to the shape of the full return distribution? But, more importantly, it is a problem for the investor because the simple answer gives a false sense of certainty.
Is the Sharpe rat…

The VIX is Not Broken

On April the 24th, the Wall Street Journal ran a story detailing the huge move of the VIX index in the opening 30 minutes of trading on the previous Wednesday. The VIX spiked up 12% in 30 minutes despite the underlying S&P 500 index not moving much at all. To put this 12% move into perspective, the current expected move in a 30-minute period is less than 2%. In addition to being a large move, the timing was suspicious. It was during this period that the settlement price for the April VIX futures was calculated. Anyone holding a long futures position would have benefitted greatly, at the expense of the shorts.
There have been rumors about the manipulation of the VIX index for many years. Whether or not the anomalously large S&P 500 option trades during the settlement period are evidence of manipulation, part of an arbitrage or just coincidence, the fact is that the VIX settlement period is often atypically volatile. This is alarming for market-makers and professional arbitrage…