Adrian Bachman, CFA Portfolio Manager, Arrow Alternative Solutions Fund

Comments & Outlook

Fear and uncertainty breed volatility in global equity markets, and for months we’ve had plenty of both. One of the most widely followed measures of market volatility is the CBOE’s S&P 500
Volatility Index (VIX), which uses a basket of options to measure the expectation of market volatility one month into the future. Since 1990, the average VIX level has hovered around 20. By November 2008, the VIX was above 80–four times the historical norm.

But were the markets really that volatile in the following month? No. Investors, being human, panicked en masse. Market expectations had clearly become irrational.

Recommended Strategy

Fear is one of the strongest human emotions and drives some investors to do things they later regret. Those investors who were fortuitous enough to buy VIX futures in August or September of last year probably did well. But since the peak volatility in November, investors looking to protect their portfolio by purchasing VIX futures have likely failed. Both realized and implied volatility have seen a dramatic decrease as investors gain a better understanding of the economic situation. When fear is replaced with understanding, even if that understanding is negative, volatility tends to come down.

Historically, the VIX tends to overestimate future volatility; realized volatility generally turns out to be much lower. Many hedge funds and institutional investors have identified this market inefficiency and try to use it to their advantage, much the same way our fund does. We capture this market inefficiency by using short variance swaps. If the actual market volatility is less than the implied VIX volatility, the fund profits.

What to Buy Now

Overestimation of future volatility isn’t just a US phenomenon. We attempt to diversify our regional exposure to this trade. We’re currently short volatility in both the Nasdaq 100 and DJ Euro Stoxx 50 markets. Typically we would also consider shorting volatility in Asian markets such as the Nikkei, but geo-political concerns (i.e., North Korea) have kept us from shorting in this region.

Sam Dedio Investment Manager, Artio US Smallcap

Comments & Outlook

We take a bottom up approach to stock selection, so we’re less concerned about bigger picture issues than other funds. That said, there’s a great deal of uncertainty about the rate at which the US economy will grow over the next few years. I tend to think that demand will slacken going forward as consumers deleverage, but there’s still a lot of opportunity out there–an entire universe of stocks.

Recommended Strategy

We look for companies that have sound balance sheets, solid cash flows and a substantial competitive advantage–whether by virtue of their size and market share, or perhaps a game-changing innovation that will improve profitability. Companies that dominate their industries are worthwhile investments, especially if their stocks fall out of favor.

What to Buy Now

Microchip Technology (NYSE: MCHP) is a leading supplier of micro controllers and other semiconductors used in a wide range of electronic devices.Some analysts have been down on the stock, citing the company’s exposure to the auto industry, but that segment only contributes about 10 percent of total revenues, and management has pared its exposure to that area. Even with that headwind and the decline in GDP, the business generates ample free cash, and the company is gaining market share. We think the company will be able to continue paying its dividend, one of the highest in the industry. The stock yields around 6 percent and offers participation in any upside once the economy starts humming again.

Weight Watchers International (NYSE: WTW) offers exposure to a US population that’s increasingly aware of the health problems associated with poor eating habits and rising obesity. This should create a long-term tailwind that will expand the company’s target market. The firm’s online business is growing and gaining market share, even contributing a higher percentage of total revenue. As of yet, the subscriber base isn’t enough to offset the cost of setting up the online infrastructure, but it’s still profitable and will quickly add to the company’s operating margins as it becomes more popular. In addition to Weight Watchers’ branded foods, the company has developed licensing deals with various packaged food makers that generate royalties and boost the company’s visibility.