Is This Lack of Fear Scary

It is now February 16th and the S&P 500 is down over 8% for the year. That is a significant
drop in value considering there have been only 29 trading days in 2016. Even more
enlightening is the volatility investors have experienced year to date (YTD).
There are two ways to describe equity market volatility:
1) The VIX, which is designed to measure implied volatility, over the next 30 days. The
average value of the VIX is 23 YTD. Put simply, this is what institutional investors expect
to happen.
2) Realized volatility or annualized standard deviation (ASTDV) of the S&P 500. So far
this year it is 22. Put simply, this is the unpleasant rollercoaster ride equity investors have
experienced this year.
Historical Perspective
To put the above numbers in context, the historic realized volatility of the S&P 500 over the
past 70 years is around 16 with an average VIX of 18; and over the past seven years it has been
closer to 12 ASTDV with an average VIX of 14. My concern is that the market is down
significantly, realized volatility is relatively high, and yet the VIX, commonly known as the
fear index, is relatively sanguine at 23. So, I ask: Is this lack of fear scary?
VIX Defined
When discussing volatility or fear, investment professionals often reference the Chicago Board
Options Exchange (CBOE) VIX Index. So I thought we would start by defining it:
The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500
stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer
of investor sentiment and market volatility. Several investors expressed interest in trading instruments related to the market's
expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006. Options
and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the
potential to diversify portfolios in times of market stress.

Two important points to take away from this description:

1. The VIX is measure of what options traders expect the behavior or implied volatility of
the S&P 500 to be in the next 30 days, not a measure of what actually happens or realized
volatility. So the VIX does measure fear, but its the fears of institutional options traders. So
when I, or other investment professionals, reference the VIX, we are describing the institutional
opinion of implied or future volatility.
2. Despite the reference to options and futures available for investors, there is no way
currently to invest directly in the VIX number. There are different ways to do it indirectly, but
there tends to be a heavy cost associated with investing indirectly in the fear index.
Fear is Justified

Lets now discuss realized volatility or what has actually happened so far in 2016. There have
been no periods where the S&P 500 is up more than two days in a row and 16 of the 29 trading
days have been negative. This volatility expands the magnitude of down markets through
negative compounding. It is important to remember that negative and positive returns are not
equal in volatile environments. A loss of 10% requires a gain of 11% to reach breakeven.
Realized volatility describes the behavior of returns but also amplifies the negative results. See
Appendix A for more examples of the negative results of volatility.
As noted in the introduction, the average VIX over the past 30 days is 23 and realized volatility
is 22. That may appear to be pretty accurate prediction, but in my opinion, the VIX is
underestimating volatility. Historically, the VIX reacts violently to environments like what we
have seen in 2016. For example, from September 2008 to April 2009, the VIX was above 40,
in the summer 2011 the VIX was consistently above 30 and as recent as August 2015 its value
was over 53. My point is that institutional investors dont appear to be scared considering how
volatile 2016 returns have been thus far.
This lack of fear scares me. Investors seem to believe that the Federal Reserve will save them,
but that seems unlikely to me. I believe the economy is generally in good shape and the low
cost of oil acts like a stimulus to the consumer. Additionally, employment and wages continue
to improve so it is unlikely that government can artificially prop up the market. Growth stocks
are at astronomical valuations as represented by the FANG stocks (Facebook, Amazon, Netflix
and Google). Margins on the S&P 500 are over 10% and well above historical norms, which
seems unsustainable. I believe that the US equity market will continue to be volatile and the
relatively low implied volatility or VIX means this will likely get worse before it gets better.
What This Means to Our Clients
Toroso manages portfolios based on three outcomes: Growth, Wealth Preservation and
Income. I want to share with our investors how we are preparing for the anticipated volatility
in each of these strategies:
1) Growth strategies:
We manage two core growth strategies; the first is our Sector Opportunity portfolio, which
combines an 80% allocation to US equity sectors with a volatility ETF overlay. In this portfolio
we seek growth through the equity exposure but protect the assets with the volatility
overlay. There are many ETFs that seek to provide exposure to the VIX through the use of
VIX futures. These ETFs have multiple inefficiencies, but further, the lack of fear this year
has made their use even more challenging. The primary ETF we use to protect client assets is
Quantshares US Market Neutral Anti-Beta (BTAL). This ETF shorts high beta stocks in the
S&P 500 while being long the low beta stocks. It has worked well in this environment as a tail
hedge and is up over 12% YTD.
In our second growth strategy, Global Alpha portfolio, we build our core exposure around two
ETFs: Alphaclone Alternative Alpha (ALFA) and Direxion Insider Sentiment
(KNOW). ALFA seeks to represent the top ideas of hedge funds while tactically providing a
hedge by shorting the S&P 500 based on downward momentum. KNOW looks to
systematically invest in companies that have relatively high level of insider buying. On Friday
February 12th, the market rallied based on the announcement that Jamie Dimon, CEO of JP
Morgan (JPM) purchased $26 million in JPM stock, this is the kind of growth KNOW seeks to

capture. The universe of equities screened for insider buying in KNOW is first reviewed for
forensic accounting anomalies providing protection from fraudulent investments. This initial
screen works as the volatility control imbedded in this ETF.
2)

Wealth Preservation:

The asset allocation strategy behind our core wealth preservation strategy, the Target Neutral
portfolio, is based on the permanent portfolio philosophy. This asset allocation philosophy has
been around for 40 years and has produced average annualized returns around 8% with a third
of the volatility of the S&P 500. In 2008, this strategy would have been down less than
6%. The portfolio employs four different asset classes, designed to offset the volatility of each
other and compound the upside potential of each component: Equities, Bonds, Gold and
Cash. This permanent allocation model is how we protect clients from the negative effects of
volatility.
The portfolio is performing well in 2016; our core neutral index is up slightly while the S&P
500 is down more than 8%. So far this year, bonds and gold are helping to counteract the
negative returns of equities. It is important to note why this strategy produced lackluster
returns the last two calendar years. In my opinion, which may sound somewhat arrogant, the
market has been irrational. For two years growth stocks have gone up with no respect for
valuation fundamentals. During this period, the market did acknowledge this type of
unsubstantiated valuations, like the down turn in October 2014 or August 2015, but the market
then recovered almost immediately negating the value of diversification. This occurred
because investors believed the Federal Reserve would continue to provide economic stimulus.
I believe this era of stimulus has ended and our wealth preservation strategy should provide
returns similar to the historic norms.
3)

Income:

In our Target Income 5% strategy, we combine high yielding ETFs with low risk cash
alternatives ETFs. This income bar-bell provides lower volatility than traditional bond
laddering or blending. In 2015, many high-income assets like Master Limited Partnerships
(MLPs) or High Yield Bonds declined substantially. Our approach is significantly more
diversified; our core position, Powershares Closed End Fund ETF (PCEF), combines 150 other
income funds, each of which has on average of 200 positions, and yields over 9%. We combine
these high income ETFs proportionally with low risk funds like the iShares Short-term
Treasury ETF (SHY) to target a 5% distribution. Today, our Target Income strategy yields
5.2% while maintaining 49% in low risk ETFs. The combination of diversification and high
percentage of low risk ETFs is how we limit volatility for investors.
In Summary
The lack of institutional fear is scary. The economy is in decent shape but I believe that the
market is still quite overvalued from a fundamental standpoint. Most probably, the realized
volatility will continue and possibly intensify. To quote Benjamin Graham, "in the short term
the market is a voting machine, in the long run it is a weighing machine; when weighed, this
market will likely continue to decline. Our outcome driven strategies seek to provide ways for
clients to achieve their goal of growth, wealth preservation, or income, while providing
protection against realized volatility.

Appendix A
Negative Effects of Volatility
The chart below illustrates the negative effect realized volatility can have on
investments. Assume that over 30 days a portfolio experienced 15 days up and 15 days down
in equal percentage amounts. The returns are positive one day and negative the next. Pay close
attention to how quickly returns deteriorate as the magnitude of volatility increases.
30 Trading Days

Number of Days

Total Return

to a 99% Loss

Up 1% / Down 1%

-0.15%

105,000

Up 3% / Down 3%

-1.44%

10,508

Up 5% / Down 5%

-4.69%

3,726

Up 10% / Down 10%

-13.99%

918

Appendix B
Returns Table Highlighting the Difference of 29 Trading Days
Total Returns
(Annualized for Periods Greater than 1 Year)
YTD
6 Mos.
1 Yr.
1 Yr.
1 Month 1 Month 3 Mos. 3 Mos.
6 Mos.
10 Yrs. 10 Yrs.
as
of as
of as
of as
of
as
of
as
of as
of
as
of
as
of
as
of as
of
12/31/15 2/16/16 12/31/15 2/16/16
2/16/16
12/31/15 2/16/16
2/16/16
12/31/15
12/31/15 2/16/16
iShares Core
US
Aggregate
Bond ETF
(AGG)
SPDR S&P
500 ETF
(SPY)
iShares S&P
500 Growth
ETF (IVW)
iShares S&P
500 Value
ETF (IVE)
FANG
Stocks*

1.79

-0.34

0.97

-0.61

1.97

0.60

1.28

0.48

1.27

4.36

4.57

-8.52

-1.57

-3.61

7.03

-8.34

0.16

-6.78

1.34

-8.83

7.22

6.09

-9.49

-1.53

-4.91

7.81

-9.36

2.56

-6.00

5.33

-7.09

8.52

7.34

-7.51

-1.69

-2.24

6.01

-7.36

-2.73

-7.88

-3.24

-11.10 5.65

4.58

-15.06 -1.53

-4.93

19.75

-10.05 34.76

4.70

83.23

35.21

SPDR Gold
16.66
Shares (GLD)
Toroso
Neutral
2.45
Index**

0.00

14.18

-4.74

13.90

-9.47

1.02

-11.78

1.00

7.12

7.90

-0.74

3.63

0.02

2.17

-2.63

-1.29

-2.35

-1.73

5.98

6.06

* The average of four stocks: Facebook (ticker: FB), Amazon (ticker: AMZN), Netflix (ticker:
NFLX) and Google (ticker: GOOGL)
** The Toroso Neutral Index is comprised of four equal weighted ETFs; Vanguard Total Stock
Market ETF (VTI), iShares Core US Aggregate Bond ETF (AGG), iShares 1-3 Year Treasury
Bond ETF (SHY), and SPDR Gold Shares (GLD).
Source: Morningstar Direct

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