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Sometimes the news pages and the e-mail inbox make it easier than usual to get a feel for the Wall Street ethos of the moment.
The cover of the New York Times one day last week featured a mostly approving article about the vogue for financial instruments that purport to insulate the wary investor from "tail risks," those highly unlikely but potentially calamitous events that can destroy wealth in a blink.
There were enough hedge-fund managers and other professionals willing to be quoted on the subject of such disaster-insurance techniques that it's clear the investment industry as a whole is quite confident in its ability to foresee and defend against potential events that almost by definition are unforeseeable. Wall Street, in other words, is busily stamping out products that would have been perfect to own three years ago, as the financial world made a fair pass at going up in smoke.
In the same week, James Montier, a portfolio manager at the always-thoughtful asset management firm GMO, posted a white paper (see www.GMO.com) on the popularity of tail-risk vehicles, which he calls "one of many investment fads du jour" -- one driven as much by a greedy desire not to "miss" the next crisis as to play prudent defense.
Montier makes the point that defining the precise risk, then designing its antidote, and then weighing exactly when one should begin shouldering the cost of carrying such insurance, is easier said -- and sold -- than done. One must, he says, be a value investor when considering all these factors, and in the end plain old cash is probably an under-appreciated cushion against bolts from the blue. "Over-engineering" is an important hazard, he notes, as "it is too easy to construct an option that pays out under a very specific set of circumstances," yet that does not by definition offer broad tail-risk protection.
Speaking of over-engineered products, a Barclays Capital exchange-traded note meant to profit from rising stock-market volatility was put to rest Friday, after having fallen below the mandatory redemption price of $10. The iPath Long-Enhanced S&P 500 VIX Mid-term Futures ETN (ticker: VZZ) began life Nov. 30, 2010, at $30 a share and will be liquidated at $10, per the terms of the prospectus. This is a fine example of something that looks better on paper than in a portfolio.
These VIX funds systematically sell nearer-term futures on the VIX volatility measure and buy more distant ones. And because the latter are almost always more expensive, the funds' net asset value steadily tends to erode. They are fine short-term trading instruments, but their inherent flaws as buy-and-hold investments illustrate how protection against abstract risks can't simply be downloaded to your online brokerage account.
This backdrop, this very long half-life of the 2008 experience, helps explain the way the clenching and unclenching of investor anxiety, often pegged to short-term data surfing and the occasional contagion scare that echoes of '08, is animating what has nonetheless been a very range-bound stock market this year. For all the drama, Greek and other, the Standard & Poor's 500 index has essentially spent all year in a 100-point range between about 1260 and 1360, with last week's 5.6% spurt taking it to the upper third of that range.
Barclays strategist Barry Knapp last week discussed this pattern in which large investors shuttle between risk-fearing and risk-embracing activity. He points out that the large volume of S&P 500 index put options that traded a week ago Friday offering protection at or below the 1200 level closed that day at $2.05, and by Thursday as the rally was well under way they were bid at a nickel.
As has been suggested here, the Greek debt saga and the end of the Federal Reserve's quantitative easing program June 30 were not the decisive factors in either the rally or the preceding decline from the April highs. Softening economic data and erosion in the credit markets were more at work, and both areas have stabilized.
This bounce in stock prices and risk tolerance, while showing no clear signs of being able to quickly carry the market above the year's highs, does show that the "growth scare" on the economy did plenty to re-set investor expectations downward, opening the way for merely "OK" data to surprise pleasantly. There's even a chance that with the perceived distortions of QE2 receding, and with public-sector budget-cutting meaning that all economic growth and more is coming from private companies, that a slower pace of headline GDP growth could be tolerated by investors -- or, at least, keep them from rushing so readily to hunker down for a 2008 replay.
E-mail: michael.santoli@barrons.com
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