There have been several articles highlighting the spectacular returns of inverse volatility product both this year and last. I shan’t go into the details but many of these products were up more than 80% last year and at the time of writing this article almost 70% this year.[1] Spectacular returns like this are hard to ignore, and reports of real trading returns are only fueling retail interest.[2]

But VIX linked Exchange Traded Products (ETPs) like VXX, XIV, SVXY and others were never designed as investments, and as I pointed out in an earlier article for Seeking Alpha ‘Making Volatility Investable’ their sponsors make this very clear in the prospectuses. VIX ETPs should instead be seen as trading tools, tools to allow active traders to express a short-term view on the volatility markets either to profit from speculation or to hedge a larger portfolio. As I recommended in that article, professionally Managed Accounts of these products offer investors one way to turn these trading tools into investable assets.

The relative stable markets of the last couple of years have unfortunately blurred this fact, but those of us who traded through the tech bubble of 1999/2000 and the financial crisis of 2007/8 remember well how seemingly stable investments quickly became unmanageable liabilities. By assuming highly leveraged banks or tech companies where stable long-term investments, many investors were caught without a plan when markets turned, many abandoning their positions and crystalizing large losses.

So what should volatility investors learn from this? Well for one that VIX ETPs are trading products and if investors are to use them for long-term investing they should commit to actively managing their exposure with a predetermined strategy or plan. Strategies offered online by ‘VIX Strategies’ and ‘Volatility Trading Strategies’ are good examples. A second point is to commit the time that is needed into managing those strategies. Some strategies offered by ‘VIX Strategies’ avoid taking overnight risk for example, and as such require daily trading at the open and the close.

For those who can’t commit sufficient time to actively trade the products, hedge funds may offer a sensible alternative.  An investment in one of the many volatility focused funds delivers exposure to the returns of one of the many approaches used to make volatility returns more investable. Unfortunately, hedge fund investing is beyond the reach of many investors, and the opaque and commingled nature of their operations, is unattractive to many investors.

Separately Managed Accounts (SMAs) on the other hand are portfolios of securities directly owned by an investor and managed according to an agreed upon strategy by a professional investment manager. SMAs frequently deliver investment returns that were previously reserved for hedge fund investors.

So what exactly is a SMA?
An SMA is a portfolio of assets placed under the management of a professional investment firm – in the United States usually a Registered Investment Advisor operating under the Investment Advisors Act of 1940 and regulated by the U.S. Securities and Exchange Commission (SEC) or one or more States. Portfolio Managers (PMs) are responsible for the day-to-day investment decisions within the account and are typically supported by a team of researchers, analysts, or strategists.

SMAs differ from pooled or commingled investment vehicles like hedge funds, mutual funds, and Exchange Traded Funds (ETFs) in that each SMA is unique to each investor, and every investor maintains complete ownership of their managed account. Investors in SMAs own their underlying securities, and the broker or custodial account that holds the account’s assets remains in the name of the investor. This is an important and valuable difference to the indirect and commingled investments held by hedge funds, mutual funds, and ETFs.

But SMAs offer at least five more important benefits over their commingled competitors, including: investment transparency, tax efficiency, individualized billing but aggregated commission discounts, and access to investable strategies with unique risk profiles. Let me explain.

Transparency

To many investors the transparency offered by SMAs is as important as their direct ownership. In addition to the periodic statements and updates from commingled fund advisors, investors in SMAs have the ability to look into their managed account and assess the securities held. This transparency is only limited by a particular brokers information delivery, and with the growth of online broker portholes and mobile apps, investors can now follow the activities of their SMA in real time.

Tax Efficiency

Commingled investments like hedge funds, mutual funds, and ETF can suffer from an embedded capital gains problem. Embedded capital gains occur because an investor does not directly own the securities in the fund when they make their investment. This can mean that the cost basis of the fund’s securities that will be used for calculating the investor’s taxes is not determined by when the investor purchases the fund, but instead by when the fund purchases a security.

With SMAs you avoid this embedded capital gains problem because investors are directly purchasing the underlying securities, and therefore have their cost basis based on the day and price their SMA purchases a security.

Furthermore, investors in SMAs can benefit from tax loss harvesting within their SMA. When the value of a security goes down, investors may see an advantage in instructing their advisor to selling stocks at a loss, and thereby reduce capital gains made elsewhere. Investors in commingled investment don’t have this same option as they only own a share in a bundled investment, and while Mutual Funds and ETFs could do this as well, because they are usually tied to a ridged methodology it is very uncommon for them to do so.

Individual Costing

Investors in commingled funds suffer a further important disadvantage – the shared cost of commissions from other investors redeeming their investments. When fund investors redeem fund shares, the fund executes the necessary trades to satisfy those redemptions and pays the brokerage and commissions on those trades. As the fund is a commingled vehicle, each and every investor participates in those fees whether they were part of the redemption or not. SMAs don’t suffer from these hidden costs but rather each investor only participates in the costs associated with their own SMA.

Furthermore, SMA managers may benefit from volume discounts at brokerages, so while each investor only incurs the fees related to their own SMA, brokerage fees could be significantly lower than if the investor had executed the trades themselves. This is a particularly important advantage of SMAs that manage active portfolios.

Unique risk profiles and Investability

Mutual funds tend to focus on diversification over performance, and lackluster performance is seeing many investors leaving mutual funds for ETFs. But most ETFs are explicitly track indexes – think about the SPY tracking the S&P 500® Index, and the SVXY tracking the daily investment results that correspond to the inverse of the S&P 500 VIX Short-Term Futures™ Index. Index tracking can be useful but in some cases – like the SPY – can suffer from some of the same over diversification issues suffered by mutual funds.

On the other hand, some ETFs, like the SVXY mentioned above track an index that many would consider ‘uninvestable’. For those who have followed SVXY and its cousin XIV will know, the volatility of the index and these products can be more than most can stomach – the XIV seeing a drawdown of more than 70% in 2011 for example. Even XIV’s sponsor, VelocityShares, points out in its prospectus that 'The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.'[1] Clearly a trading vehicle rather than an investment.

But an actively traded SMA managing these Exchange Trades Products could help access some of the returns inherent to the underlying indexes without suffering as much of the ulcer inducing drawdowns. Active management of a SMA can thereby make an otherwise uninvestable asset class into a more palatable investment and allow investor to access returns previously unavailable.

SMAs are however not without their drawbacks. For one, less comprehensive information is available on the SMA industry than on the mutual fund industry and the customized nature of each relationship means benchmarks are difficult to set. For these reasons the reputation and track record of an SMA’s manager is paramount, particularly in the manager’s ability to offer expertise in the specialty that the SMA is customized towards.

Footnotes

[1] In 2016 XIV rose 80.84%, and as of June 20, 2017 XIV was up 69.65% year to date. Source: Yahoo Finance.

[2] The Snowballing Power of the VIX, Wall Street’s Fear Index, June 12, 2017. The Wall Street Journal. Available here.