Wednesday, May 13, 2009

Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock

I am going to make this a Gateway post for managing risk in a disfavored asset class, namely equity preferred securities with no maturity date, and I will include some new discussion.

I have discussed volatility in connection with two topics. The most important line of discussion in this blog is the use of the VIX as an asset allocation tool for long term shifts into, and out of stocks, as an asset class. The Gateway post on this topic is-USING THE VIX MODEL AS A TIMING INDICATOR FOR LONGER TERM STOCK ALLOCATIONS

I am not set up to do a software program with sophisticated mathematical equations. I do simple math. My main reason for choosing to go to Tulane in 1969 was that I would be allowed to substitute Philosophy  for Calculus. So my observations of the correlation of the VIX with bull and bear cycles is based on observation and common sense. A statistician might call the relationship between the movement of the VIX and the directional move of the S & P 500 a negative correlation, and a highly correlated one.  Correlation 

Today, as of the noon hour, the VIX was up 5.5% and the S & P was down 2.6%. This is what I understand negative correlation to mean. For longer term stock allocations, the VIX is like that canary in the coal mine. If you think that it is safe to be in stocks with the VIX below 20, showing a steady movement over a long period below 20, and then it shoots up to 30, the canary has just died. 

I also believe that individuals need to embrace a particular securities unique volatility profile to manage risk in just that one position. The illustration that I have used is the price action of INZ, an ING preferred stock, since October 2008, when I started to embrace its volatility as a means to manage risk, using both its up and down movements.

At the end of that process, I realized several gains along the way, captured some dividends taxed in the U.S. at 15%, and now hold, and will likely continue to hold, the lowest cost INZ shares that I have ever purchased, content now to just collect my quarterly dividends at the yield based on my cost. After all of that trading, I have a 50 share position in INZ purchased at $6.52 in a taxable account, yielding almost 28% based on my cost, and 50 shares in an IRA at $7.82. I also own 200 IND and 50 ISF, so the position overall is not material in my portfolio. I have used this trades as an illustration on how to embrace volatility and turn it to your advantage. I also discussed this topic as it relates to the ING Preferred in this post:

More on Dynamic Asset Allocation & The Use of Volatility As one Tool Among Many to Manage Asset Mix and Securities within Asset Categories

The same process has been ongoing in another volatile class of securities, the REIT cumulative preferred issues. I am not so much managing each individual security in that category but attempting to manage the entire class as a group to secure my current goal of 15 to 20% returns. This requires a number of different trading rules. Some have to be sold on pops, others have to be purchased at the maximum period of investor pessimism (like the GRTPRF at $2.9 yielding 75%) and others may need to be sold at a loss before it becomes too great.

I am adjusting my goal for this sub-asset class based on my performance managing it, and I recently raised the goal from 10 to 15% to 15 to 20% per year. Trading Rule for Disfavored Asset Class: Sold BDNPRC and Late Buy of Just 30 Pico REITs in Barron's/ Clarification on Qualified Dividends & REITS/Condi Rice Interview by Stanford Students: If the President Does it, Then it is Legal  

So LB has trading rules just for this sub-asset class of equity preferred stocks that have been classified as a small component in the bond section of the portfolio. 

Why trade these securities in this way? The simple answer is because they are volatile. But why are they so volatile?  It is due to the way they are perceived from day to day in the current economic environment.  Both the REITs and financial companies have suffered more than most as a result of the current economic downturn. This creates a substantial amount of increased risk, more opportunities and certainly a heightened level of volatility which has been embraced as a friend rather than an enemy at this trading desk.   

I would add this caveat.  Many of the REIT cumulative preferred securities that I have bought were purchased knowing the danger after doing a lot of research. There are no free lunches for a security paying 75% annually. GRTPRF: A WALK ON THE WILD SIDE/ KTN add There is just a huge amount of risk for that kind of return. All that I can say now for a security like GRTPRF is that I have received two dividends to date and  GRT is still paying the common dividend. Maybe I will let it ride at least until there is some really adverse development for this REIT. Or re-consider if and when the common dividend, my security blanket, is eliminated.   

One thing is for certain. I could not buy these securities at par value and just hold them. Most of the REIT preferred securities that I currently own were selling at near par value in 2007. So buying at anywhere near par value and holding them indefinitely is not a viable strategy. The current strategy that I have been following for the past several months appears to be the viable one for this sub-asset class.   

I would add another caveat. It should not matter to you who I am or what I do with my money. It should only matter if I am making any sense to you. So, although I say that I used the VIX Asset Allocation Model to reduce exposure to stocks in 2007, that is irrelevant to my discussion to anyone but me. The only relevant part of my discussion on the VIX Asset Allocation Model to a reader is whether the model would have been useful in the past as a timing indicator to reduce exposure to stocks.  

Some of the prior posts which discusses the topic of managing risk using volatility as your friend in the sub-asset class of perpetual equity preferred issues, plus some others including ones about specific trades in furtherance of risk management, are also linked above and more below: 

(Except for a few sales prior to the commencement of this blog in October 2008, I have managed risk in the floater category primarily by being an opportunistic buyer rather than trading volatility. In other words, waiting and watching until volatility brought the price down to a very appealing level, as in buying AEB at $5.5 and less than $ 5 or METPRA at $7. This requires some patience but I could have used the same technique as I followed with the ING or the REIT cumulative preferred issues. I just chose to buy at a good price for the floaters and then hold, wait and see what happens, so the discussions on the equity preferred floaters are mostly linked in their Gateway post) 

I will add more post to this Gateway Post as I find them, and any new posts that are relevant to its topic.  

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