Understanding Volatility and What it means to your Portfolio

HorizonsETFs.com

Understanding Volatility: What is the VIX

and What Does it Mean for Your Portfolio?

February 2013

ETF solutions for every investor™

Eden Rahim, VP & Portfolio Manager, Options Strategist

2 A Member of Mirae Asset Financial Group

“Markets are constantly in a state of uncertainty & flux, & money is

made by discounting the obvious & betting on the unexpected”

George Soros


Outline

Why volatility impacts our decision-making

Distribution of market returns over time

VIX: how is it constructed & why?

What causes volatility?

Volatility as a barometer of market uneasiness or complacency

Volatility as a tool to forecast market direction

New frontiers of analysing turbulence


The Great Modulation

Source: Adaptive Markets & New World Order, Andrew Lo – January 2nd, 1926-August 9, 2006

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Overview

Volatility is about the uncertainty of a possible bad outcome, and how it

impacts our decision-making

Our future expectations are impacted by low volatility in an asymmetric way to

how it is when volatility is rising: comfort vs. fear

Every investor has a different way of coping with risk and volatility and must

find the level with which they can deal with it. Decisions about managing risk

are inherently subjective, so a ‘one size fits all’ solution is inadequate.

Over the past year, we’ve designed different portfolio hedges for Canadian

insurance company & U.S. hedge fund, each with a different aim to be

addressed

Best decision combines your expectations about possible outcomes &

preference for payoff


Investors confront Volatility in 3 general ways:

1. Passively – it’s part of all markets and must be endured,

2. Hedge against by taking steps to dampen it by either:

I. going to cash,

II. diversifying to non-correlated assets & ETFs,

III. buying put options or

IV. buying securities that rise in value with VIX,

3. Volatility as an asset class - agnostically seeking profit on both a rise and

fall in volatility.


About the VIX

Designed by Robert Whaley and launched in 1993

Has become the ubiquitous measure of market Volatility and Uncertainty

It is a measure of the average implied volatility of 8 index options on S&P

Composed or current month ATM and first OTM call and put options,

and same for next month

With a week to expiration, the front month is rolled to the 3rd month.


TSX Distribution of Daily Returns Pre-Crisis vs Post Crisis

Distinctly fatter left-tail & smaller percent of small gains

Source: HIMI, May 2008-February 2013

Source: HIMI, January 1980 to April 2008


Annual Distribution of Equity Returns is Right-tailed (142 Years)

Source: Horizons Investment Management Inc. , Annual Distribution of Returns, 1871-2013


Volatility Cycle: Simmer, Spike, Aftershocks, Decay, Steady-State

Source: Bank of America Merrill Lynch Research


What Causes Volatility? Distilling Telegraphed Forecasts

NOT HEADLINES! Fiscal Cliff = Y2K

When stocks become strongly correlated

Widening credit spreads / inverting treasury yield curve

Frequent two-way gaps & swings – even if in a small range

Leverage effect: As equities fall, balance sheet leverage increases

Deleveraging & credit unwinding, leading to illiquidity

Pressing need for hedging: Insurance costs most when your house is on fire

Fight-or-flight fear when bad outcomes seem inevitable & assurances of

‘Experts’ become hot air.


Skew: How Much More you Pay for OTM Puts vs OTM Calls:

Impacts the cost of hedging with options

Reflects relative cost of bearish vs. bullish hedging expectations

Costing the lowest amount for put protection relative to calls in 2 years

Source: B of A Merrill Dec 31-95 – Feb 1-2013


Up by the Escalator, Down by the Elevator

Pre-1987 Crash vs. Post crash options ‘SMILE’

Source: JOF, Vol 101, Issue 3, Sept 2011

Pre- and post-crash implied volatility

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Moneyness =K/S0-1

Pre crash

Post crash

0.1 0.5 0 -0.05 -0.1 14

16

18

20

22

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Rising Correlation of Stocks Causes Rise in Volatility

When a market becomes stressed, strong stocks break down & join weak

stocks

Diversification ceases to buffer & most stocks become unstable together

Component volatility rises & each company trades with higher volatility

Indexes face macro & systemic risk offset by dampening of diversification

In contrast, companies have both risks, plus risks such as earnings

expectations, obsolescence, competition, pricing, demand, cost of credit,

leverage

A stressed market brings these into focus & re-prices company risk higher

Source: Bloomberg Data, Horizons Investment Management Inc. November 22,2010-November 22,2012


Volatility is Correlated to 5 Year Corporate Credit Spreads

Regression Of S&P Volatility (VIX) vs IG Credit Spreads (CDX IG 5 Yr)

Source: HIMI


Two-Year Swap Spread Vs. VIX

The spread at which 2 year fixed rate is exchanged for floating rate exposure

During poor liquidity or increasing turbulence in the credit markets, floating

rates reflect the current credit risk, while those in fixed rates are insulated

So those with fixed rates must be compensated for taking credit risk off the

hands of firms that need to exit that risk and go to cash

Note years before the financial crisis in 2008, this spread was rising

Source: Bloomberg, 1989-2013


Inverting Yield-Curve Lead Changes in Volatility Cycle by 2 Years

Source: Horizons Investment Management Inc., January 31, 1989-January 31, 2013

Inverse 105 – 25 Yield Curve


At Turning Points, Internal Intraday Volatility Telegraph Turbulence

Market becomes internally unstable before turns

Source: Horizons Investment Managemenet Inc. May 12, 1997-May 12, 2012


Level of VIX has Implicit Probability Forecast of Future Direction

Source: BAMI

Unlike equity, the distribution of volatility is heavily

dependent on its level, one of the factors that makes

volatility more predictable

When VIX is

higher than its

median, future

changes are

skewed to the left

When VIX is lower

than its median,

future changes are

skewed to the right

3 Month Change in VIX

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VOL-of-VOL (VVIX) More Bounded and Responsive to VIX Changes

Only briefly pays to be long volatility

Volatility mean regresses quickly & spends most of time in low volatility zone

“Just-in-time” hedging has superior pay-off return

Tail-wagging-the-dog: anticipating volatility increases can be costly (Q1:2012)

Variance swap did well in that period

Source: HIMI, CBOE


Positive / Flat VOL Curve is Normal & Prevalent

INVERSION tends to signal market lows

Source: BoA Merrill Lynch Global Research (March 26, 2004-August 7, 2012)

It takes more stress to cause term structure inversion now than in

previous years


Hurricane at our Doorstep: How VIX Curves Fluctuated During 2007-2009 Crisis

Source: Horizons Investment Management Inc. & CBOE, Data as of April 2, 2007-December 31, 2010

S&P and Phases of Change in VIX Forward

Curve During A) Topping B) Orderly


Hurricane at our Doorstep: How VIX Curves Fluctuated During 2007-2009 Crisis

Source: Horizons Investment Management Inc. CBOE


VIX Curve Spends Almost 80% of Time in Contango

In year with extreme drawdown, the market looks out and says “This is

unsustainable” and prices future Volatility expectations into Backwardation

Source: CBOE from January 1st, 2007 through December 31st, 2012

Trading Days Contango Backwardation % Contango % Backwardation

2007 251 177 74 70.52% 29.48%

2008 253 143 110 56.52% 43.48%

2009 252 202 50 80.16% 19.84%

2010 252 223 29 88.49% 11.51%

2011 252 178 74 70.63% 29.37%

2012 221 221 0 100.00% 0.00%

Total 1481 1144 337 77.25% 22.75%


Current Volatility Curve Extremely Steep (>80th Percentile)

Source: CBOE.com, data February 16,2013-December 20, 2014


Misbehavior of Markets by Benoit Mandelbrot

Father of chaos theory & fractal geometry,

turned MPT on its head

Markets are fractal, exhibit self-similarity &

scales with time

Markets are more risky than bell curve

suggest

Turbulence runs in streaks & clusters

Power laws better explain volatility spikes, as

it does cascade dynamics of fluid turbulence,

avalanches, earthquakes, solar flares….

Much of what we deem predictable is in fact

market noise

Market time is relative, expanding &

contracting with volatility


Interestingly, VIX Follows Power Law Distributions

Non-Financial work of Zipf’s law (physics), Navier-Stokes (combustion engine) & Omori

(seismology) better explain behavior of Volatility outbursts

Volatility ebb & flows in negative feedback loop until is pushed into positive feedback

that results in cascade spikes

Source: HIMI


Hedging: PUT Options vs Long VIX Products

Unlike Put Options, VIX products require 4 simultaneous bets: direction, path,

volatility increase, & shift in shape of curve

1. Both hedge against downside directional moves

2. Puts respond almost immediately while VIX is delayed

3. Puts benefit if market moves down without increase in Volatility ie. orderly

decline, while VIX requires an increase in Volatility

4. Puts are not concerned with the Volatility curve, while a shift in curve may

impact where long VIX product is profitable even in down market


Summary

Volatility impacts our decision making, requiring an actionable roadmap

Position for normal volatility, be alert to signs when it’s becoming abnormal

One size doesn’t fit all: every investor has own tolerance & return expectation

Investors greet volatility either passively, to be hedged, or traded

VIX has become the ubiquitous barometer of market uncertainty

Since the crisis, daily returns have become more ‘left-tailed’ distributed

Each phase of volatility must be confronted uniquely: simmer, spike, aftershock, decay,

& steady-state

Volatility impacted by: correlation, credit spreads, leverage, yield-curve & fear

Level & curve of volatility is itself a forecast. That can be said of few assets

Cascade dynamics & power laws best explain turbulence of volatility

Tools have existed for a 150 years to dampen & distribute risk

Horizons ETFs offers 3 volatility ETFs HVU HUV HVI


Disclaimer

The views and opinions expressed herein are of a general nature and the suggestions are not and should not be considered as advice to purchase

or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

Commissions, trailing commissions, management fees and expenses all may be associated with an investment in exchange traded products

managed by AlphaPro Management Inc and Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons

Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. Please read the

relevant prospectus before investing.

The Horizons Exchange Traded Products consist of the Horizons Index ETFs ("Index ETFs"), Bull Plus and Bear Plus ETFs ("Plus ETFs"), Inverse

ETFs ("Inverse ETFs"), VIX ETFs (defined below) and active ETFs. The Plus ETFs and certain other Horizons Exchange Traded Products use

leveraged investment techniques that magnify gains and losses and result in greater volatility in value. These Horizons Exchange Traded Products

are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, which, where applicable, are described in

their respective prospectuses. Each Plus ETF seeks a return, before fees and expenses, that is either 200% or -200% of the performance of a

specified underlying index, commodity or benchmark (the "Target") for a single day. Each Index ETF or Inverse ETF seeks a return that is 100% or

- 100%, respectively, of the performance of a Target. Due to the compounding of daily returns, a Plus ETF's or Inverse ETF's returns over periods

other than one day will likely differ in amount and possibly direction from the performance of their respective Target(s) for the same period. The

Horizons Exchange Traded Products whose Target is the S&P 500 VIX Short-Term Futures Index™ (the "VIX ETFs"), one of which is a Plus ETF

and one of which is an Index ETF, as described in their prospectus, are speculative investment tools that are not conventional investments. The

VIX ETFs' Target is highly volatile. As a result, the VIX ETFs are not generally viewed as stand-alone long-term investments. Historically, the VIX

ETFs' Target has tended to revert to a historical mean. As a result, the performance of the VIX ETFs' Target is expected to be negative over the

longer term and neither the VIX ETFs nor their Target are expected to have positive long term performance. Investors should monitor their

holdings, as frequently as daily, to ensure that they remain consistent with their investment strategies.

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Date post:	14-Jul-2015
Category:	Economy & Finance
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Understanding Volatility and What it means to your Portfolio

Economy & Finance