Another Fund Blows Up

Selling puts at a top is a very bad idea.

Jesse Felder Tweeted out the following;
'The LJM Preservation and Growth Fund's net asset value halved on Monday and halved again on Tuesday.' https://www.ft.com/content/d0dd673c-0c71-11e8-839d-41ca06376bf2 ht @lisaabramowicz1

The fund in question is the LJM Preservation & Growth Fund (LJMIX). It bills itself as a liquid alternative. The high level view of the strategy is to profit from the difference between implied volatility and realized volatility by using options. A little more narrowly, from the literature; "The LJM strategy aims to capture this volatility premium by writing (selling) options. The fund’s investment managers will also buy options to help mitigate the impact of sudden price moves and potentially add incremental return." It is a variation on the short volatility trade which is what blew up the VelocityShares Daily Inverse VIX Short Term ETN (XIV) earlier in the week.

As best as I can tell though, LJMIX uses S&P 500 calls and puts while XIV used VIX futures. LJMIX views volatility as an asset class with potential benefits including "enhanced portfolio diversification, improved risk adjusted returns, uncorrelated return stream."

There was also this in the literature; "Investors commonly associate market volatility with instability and uncertainty. But volatility can be harnessed to target a return stream uncorrelated with the equity and fixed income markets." It sounds sophisticated which creates an intrigue and before this blow up there was a negative correlation to the S&P 500. So what went wrong?

I won't know all the answers but in looking at these sorts of things (alternatives) and whether they can help insulate a portfolio during a bear market it is possible to detect any serious threats without fully understanding the strategy. Look at the positions and you will see calls and puts on the S&P 500. The literature tells you they sell options, that is the primary strategy. They also buy some options but selling appears to be the primary trade. If there are both calls and puts and they sell options that means they sold puts. As I have written about twice, once about PUTW and more recently RPUT, both from WisdomTree, selling puts when the market is high is a very bad idea. The title to the PUTW link in the last sentence is A Potentially Disastrous Alternative Strategy. As I said in the second link, the one about RPUT, the time to consider selling puts is after a large decline not perpetually as the market is going higher.

In terms of being able to sort this out ahead of time, before LJMIX imploded there are couple of flashing yellow lights here even if you don't fully follow the strategy (I may not be fully following). Before you even dig in to the literature it tells you volatility is an asset class. Without letting them explain it to you, do you understand how volatility can be an asset class? I am not sure I do, but if I do then based on what little I understand about it, I disagree with the conclusion. The strategy uses options on equities to try to profitably exploit equities' volatility. All volatility measures I am aware of are derivatives of some other asset class, not their own asset class. It should sound complicated, the fund managers appear to say it is complicated.

Back to selling options. When you sell a put on a stock you are obligated to buy stock at the option's strike price at the discretion of the put buyer. 3M (MMM) closed today at $222. Selling a put with a strike price of $220 is out of the money by $2. If the stock stays above $220 the put will expire worthless which is a good outcome for a put seller because they get to keep the premium with no further action. If the stock drops to $218 then the put seller should expect that they will have to buy at the strike price $220. They would keep the premium (good) and will have bought the stock $2 higher than what it was trading for in the open market. Not terrible, making back the $2 doesn't seem impossible. But what if instead of dropping a couple of percent, 3M cut in half. The put seller would be paying $220 for stock trading at $110 in market. That's a lot of money evaporated.

Index options work a little differently, you simply pay the difference in cash at expiration if the trade loses money. What likely happened to LJMIX is that the puts it sold have gone up a lot in value (that's what happens to puts when the market goes down) and the fund probably needs to mark the puts to market (reflect the adverse price movement in the fund's net asset value).

Here's a chart of what PUTW and RPUT have done in the decline;

As I said before, I don't think these can be good bear market tools. The things I have been writing about in this regard have done better. Inverse funds and the anti beta fund are up in this correction. Gold, merger, managed futures and hedge fund replication are down much less. If that doesn't appeal, then as I say don't use them. Aside from my general belief in those six alternatives, they tend to be much simpler with the exception of managed futures. While I like managed futures, if you look into the strategy and you don't understand it, don't use it!

Finally, the market is in the middle of a panic. A 10% decline in a week is a fast decline, it is a panic. The historical tendency of panics is that they are short lived. None of my indicators for defensive portfolio action have triggered as of Thursday's close. I will heed those indicators if they do trigger and will spell out what I do here, after I do it.

Good to know none of your indicators have triggered. I lightened up a smidge last Friday, only a few percent of total, but am willing to double or triple that going back in soon. The question is when?!

A breach of the 200 day moving average for the S&P 500 is close but hasn't happened yet.