In spite of a couple of negative days on European and US markets the ASX200 just doesn't want to take a breather, even after rising over 25% from the lows of last June. While most fund managers, and even some brokers are concerned the market might be getting ahead of itself, there seem to be plenty of investors who are determined not to miss out - even though they would go near equities just six months ago.

AFM's Research Manager, Sean Webster has taken a look at the curious behavior of the VIX, the so called Fear Index, and it reverse correlation to the market: Taking a lead from an article published by Adam Hamilton in the US, the logic seems curious - that if the market has had a strong rally, investors lose their caution and become complacent. However the reality is often that the market is overbought, and therefore has a higher probability of a correction.

The cost of insurance however, as measured by the VIX, falls simply because there's less demand for protection. The reverse applies when the market has fallen sharply, and therefore stocks may offer better value: All of a sudden the cost of protection (the VIX) skyrockets as investors try to buy insurance after the event.

Sean's article and associated charts can be seen here. It's a moot point of course whether the VIX leads the market, or the market leads the VIX. What it does show however is that potential risk is always around the corner and investors ignore risk at their peril.

Meanwhile there's plenty of media coverage about incidents (some actual, some alleged) of insider trading, both in Australia and overseas. Last Saturday's AFR contained an interview with Belinda Gibson from ASIC and covered the attempt by an offshore fund manager trying to gain early access to a local broker's research and information. Aspects of trading in Heinz in the US ahead of Warren Buffett's recent proposed purchase are being investigated, and a major US hedge fund is also in the SEC's sights.

However as we argue in this article, institutional investors, including hedge funds get access to information not generally available to ordinary investors, whether by their added research capacity, by investor briefings directly from the company itself, or through broker presentations. There may be no insider trading involved, but there is certainly no level playing field either.

This week's now for something completely different contains not one but two completely different clips. We hope you share our appreciation of The Two Ronnies, who still make me laugh even though the material is now well dated. Our second clip is far from amusing but well worth watching: Last Monday's "Australian Story" on the EasyBeats' lead singer Stevie Wright on ABC TV was a chilling reminder of the dangers of drugs. It's a long clip, so if you're short of time watch it from about 4 minutes onwards. The program is re-broadcast on the ABC at 12:30pm Saturday afternoon. Record it and play it to your children.

Otherwise enjoy the week-end.

Regards,

Chris.

Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril.

A recent article (January 2013) by Adam Hamilton of Zeal LLC examines the role of the VIX as a leading indicator for the S&P 500. In the current bullish climate for equities and very low levels of volatility this might be a timely reminder that risk is often present when least expected.

We have reproduced the chart from the Zeal article and also added a chart of the ASX and a local volatility index. Meanwhile the full Zeal article can be found in this link.

Hamilton points out that the US market has had a strong rally with stocks at their best levels is 5 years and the S&P 500 (SPX) recording 8 new cyclical highs in 13 days. However the gains have been marked by very high levels of complacency by investors, and as contrarians would be aware, most investors become bullish only after major rallies.

The issue for investors is how best to measure the bullishness or complacency of the market. Over time a number of indicators have been developed with the best based on the option trading concept of implied volatility. Given that traders buy options to bet on future price moves investors can analyse how fast they expect markets to move in the near term. The most well known indicator here is the VIX. It is commonly known "the fear gauge" i.e., the higher the implied volatility the more fear is being reflected in the VIX and vice versa.

Hamilton's article notes that the author prefers to use VXO index as opposed to the VIX and details the rationale for this. In summary the VXO looks at near-term at the money S&P 100 options, as opposed to the VIX which amongst other differences uses the S&P 500.

Read the entire article from Sean Webster here.

ATTACHED FILESIs low volatility a sign of low risk, or investor complacency? (pdf format)

An article by Tony Boyd in Saturday's AFR bought up the key words of "hedge funds" and "insider trading" which is always good for a headline if nothing else. The Article was focused on ASIC's concern that some investors might be trying to access broker research on specific companies prior to it being released to all clients, and thus being generally available.

This has some serious implications especially as a number of overseas funds have been caught up in insider trading investigations, most recently SAC Capital in the US where an individual is under investigation by the SEC, which has resulted in redemption notices for over $1.7bn being lodged by the fund's external investors. That's a significant chunk of external money, which reportedly only makes up about 50% of the total external FUM - the balance being internal - founders' and staff.

Back to the AFR, where the article focused on a large global, offshore fund trying to access a broker's research prior to general release. As an ex broker I can recall plenty of instances of some investors knowing what's in the research pipeline, and there's obviously a grey area between company information, and broker disseminated information. There's no doubt that large institutional investors, including hedge funds get access to information not generally available to retail investors, whether by their added research capacity, or by investor briefings directly from the company itself, or through broker presentations.

This became more and more of an issue as institutions established formal broker panels post the '87 crash, with a heavy weighting to the quality of individual research analysts as part of the process. Meanwhile many institutional fund managers promote the number of company visits they make each year as one of their key strengths. Even though they may not be provided with what might be conventionally termed inside information, they are certainly ahead of the information curve compared with retail investors.

The difficulty here is how strictly to draw the line between "dodgy, and deliberate" inside information, such as that being investigated over option trading in Heinz's stock prior to last week's proposed acquisition by Warren Buffett, and "general information" provided by brokers or management.

The reality is that institutional investors, hedge funds or otherwise, will ALWAYS be at an information advantage. They have the resources to analyse research, they often have access to company management, and they certainly get first look at placements, which are often only offered to institutional and large shareholders. So where does one (or in this case ASIC) draw the line?

Of course anything "deal" related is over the line, but at what point does "unfair" advantage come in. If I go out onto the footy park (not a good sight), or a fun run (what's fun about a fun run?) there are plenty of other competitors (usually 99% of them) who have an advantage over me courtesy of age, training, excess alcohol intake (mine not theirs) not to mention the use of supplements or even legally prescribed peptides.

I'm all in support of transparency and a level playing field in broker research, but it is incredibly hard to define, and harder to enforce.

The Australian equity market rally has now seen the ASX200 rise over 8% YTD, and 26% over the past 12 months, driven not only by the rotation out of cash and term deposits which drove the high yielding banks higher, but more recently also into previously unloved discretionary consumer and retail sectors.

As a result some of the concentrated, high conviction funds which had struggled over the previous 3 to 4 years have enjoyed stellar, above market performance. Meanwhile the risk averse long short and market neutral funds which had previously protected investors' capital have struggled to find value at current prices. This has been further exaggerated by some aggressive price moves amongst their short positions where valuations have been stretched even further.

In this environment active and absolute return funds as a whole are likely to underperform, as indicated by the table below based on 53% of funds which have to date reported January results:

These are averages, and there have been some significant outliers. 21% of funds in the AFM index outperformed the ASX200's return of 4.95% in January, and 35% have achieved this over the past 12 months. Conversely, 11% of fund returns for January to date have been negative, while 14% have returned negative performances over the past 12 months.

The improved performance and sentiment is welcome, but following 7 straight positive months, and gains in many stocks of over 100% in 2012, it is worth remembering that risk is always present around the corner, often when it is least expected.

This reiterates the focus on the need for research and investors' understanding. We have just completed collating industry figures covering fund and strategy performances not only for 2012, but also for five and ten years since 2008 and 2003 respectively. What the data clearly shows is that over the longer term the average absolute return fund has performed above (5 years) or in line (10 years) with the ASX200 but at a fraction of the market's volatility.

For a copy of AFM's "Volatility eats Returns" report please email us.

Finally, Now for something completely different this week, the 2 Ronnies Name Dropping; or if you find something a bit more risque amusing, try this one.

Regards,

Chris.