Has Volatility Reached a Permanently Low Plateau?

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1 Has Volatility Reached a Permanently Low Plateau? Frank Brosens For illustrative purposes only does not constitute investment advice. 1

2 The views expressed in this commentary are solely those of the presenter as of the date of this commentary. The views expressed in this commentary are subject to change without notice. This commentary is provided to you for informational purposes only and does not and is not intended to constitute investment advice, nor does it constitute an offer to sell or a solicitation of an offer to buy any security or investment product.

3 HOW DOES PORTFOLIO INSURANCE WORK? $30 $PnL of Synthetic Put Replication $100 Portfolio, 2yr 10% OTM Put, Initial Hedge -$30 Adjust futures position for every 1% move in the portfolio $20 $10 $0 ($10) Replicated Put PnL ($20) Uninsured Portfolio PnL Insured Portfolio PnL (Port. + Put) Cuml. Buy/Sell for Put Replication ($30) $70 $80 $90 $100 $110 $120 $130 Underlying Market Portfolio Value

4 VALUATIONS THEN AND NOW Price-Earnings Ratio (CAPE, P/E10) Long-Term Interest Rates 1929 Price-Earnings Ratio US Cyclically Adjusted Price/Earnings Ratio Source: Online Data by Robert Shiller Long-Term Interest Rates US Market Capitalization to GDP % 140% 120% 100% 80% 60% 40% 20% 0%

5 Source: A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response (Carlson, 2013) WHAT HAPPENED DURING THE 1987 CRASH? S&P 500 Index Daily Source: A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response (Carlson, 2013) Source: Report of the Presidential Task Force on Market Mechanisms (Brady Report, 1988)

6 Strategies Similar to Portfolio Insurance Today Volatility Targeting SPX Returns vs. Realized Volatility Tendency for Leverage to Decrease as Market Drops & Volatility Rises Vol. Targeting Leverage Ratio (SPX, 12% Target, 1.25 Cap) 1 Month Change in Realized Volatility 30% 20% 10% 0% -10% y = x R² = % Realized Vol. - 5/4/1976 5/4/1977 5/4/1978 5/4/1979 5/4/1980 5/4/1981 5/4/1982 5/4/1983 5/4/1984 5/4/1985 5/4/1986 5/4/1987 5/4/1988 5/4/1989 5/4/1990 5/4/1991 5/4/1992 5/4/1993 5/4/1994 5/4/1995 5/4/1996 5/4/1997 5/4/1998 5/4/1999 5/4/2000 5/4/2001 5/4/2002 5/4/2003 5/4/2004 5/4/2005 5/4/2006 5/4/2007 5/4/2008 5/4/2009 5/4/2010 5/4/2011 5/4/2012 5/4/2013 5/4/2014 5/4/2015 5/4/2016 5/4/2017 * 1-2 month half-life used for realized volatility Change in Leverage Ratio -30% -20% -15% -10% -5% 0% 5% 10% 15% 20% Month SPX Return SPX Returns vs. Change in Leverage Ratio y = x R² = % -15% -10% -5% 0% 5% 10% 15% 20% 1 Month SPX Return

7 Strategies Similar to Portfolio Insurance Today Risk Parity Tendency for Leverage to Decrease as Market Drops & Vols (and Possibly Correlations) Rise 60% 50% 40% 30% 20% 10% 0% Realized Vol 10/19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/2016 * 1 year lookback used for volatility & correlation statistics $MV/AUM (Asset Class Leverage) 10/19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/2016 US 10yr Vol SPX Vol Comdty Vol US 10yr SPX Comdty (0.20) (0.40) (0.60) (0.80) () Total Leverage 1.50 Realized Correlation 10/19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/2016 Rule of Thumb: Sum of Volatilities and Correlations vs. Total Leverage Total Leverage (left axis) Vols + Corrs (right axis inverted) /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/ /19/2016 Stock/Comdty Bond/Comdty Stock/Bond (0.20) Sum of Vols + Correlations

8 Strategies Similar to Portfolio Insurance Today Trend Following CTAs Equity Exposure Decreases and Eventually Goes from Long to Short as Market Drops 4.00 Leverage Ratio of SPX Allocation Leverage Ratio of SPX Allocation in CTA Model 2.0 SPX Returns vs. Change in Leverage Ratio of SPX Allocation m. Avg. Log SPX Index Change in Leverage Ratio of SPX Allocation /9/1978 3/9/1979 3/9/1980 3/9/1981 3/9/1982 3/9/1983 3/9/1984 3/9/1985 3/9/1986 3/9/1987 3/9/1988 3/9/1989 3/9/1990 3/9/1991 3/9/1992 3/9/1993 3/9/1994 3/9/1995 3/9/1996 3/9/1997 3/9/1998 3/9/1999 3/9/2000 3/9/2001 3/9/2002 3/9/2003 3/9/2004 3/9/2005 3/9/2006 3/9/2007 3/9/2008 3/9/2009 3/9/2010 3/9/2011 3/9/2012 3/9/2013 3/9/2014 3/9/2015 3/9/2016 3/9/2017 * 1-4 month momentum signal, risk adjusted by recent volatility -2.0 y = x R² = % -20% -15% -10% -5% 0% 5% 10% 15% 1 Month SPX Return

9 Strategies Similar to Portfolio Insurance Today Daily Levered Equity Index and VIX ETFs $100 AUM Example End of Previous Day End Day Before Rebalance Rebalance at Close Fund Type Index Level AUM Net Assets Owned Index Level Net Assets Owned $PnL AUM $Trade Net Assets Owned 2x Long Fund 100 $100 $ $190 ($10) $90 ($10) $180 1x Short Fund 100 $100 ($100) 95 ($95) $5 $105 ($10) ($105) For 2x long and 1x short, funds need to buy/sell 2x percent of AUM for every percent move in Index to achieve Assets = Leverage (-1 for short) x AUM at close $ Millions $4,000 $3,500 $3,000 $2,500 $2,000 $Millions of SPX Beta Equivalents to Sell for -1% SPX Move *Increase in VIX due to strong inflows into short ETFs and SPX beta increase from VIX decrease Top 10 Levered US Equiy Index ETFs Top 5 Levered VIX ETFs $1,500 $1,000 $500 $- 8/30/2010 8/30/2011 8/30/2012 8/30/2013 8/30/2014 8/30/2015 8/30/2016 8/30/2017

10 Strategies Similar to Portfolio Insurance Today Dealer Option Positioning Illustration Based on Covered Call Fund Positioning & Hypothetical Dealer Put Positioning

11 ESTIMATED COMBINED SELLING IN MARKET DROP

12 HAS VOLATILITY REACHED A PERMANENTLY LOW PLATEAU?