Digging into ING US (VOYA)

After taking a position in ING US (NYSE: VOYA) at about the $25/share level, I have been fortunate to participate in the rise to above $30. The original target was around the 40-50$, with stop around $20, the ipo price. The recent rise and earnings report make this a good time to reevaluate the thesis.

The firm posted an operating gain of $0.71/share, but on a net basis lost $0.56/share. Why? In a phrase, variable annuities (p134-135). Variable annuities took a (408.4) million capital (loss) related to hedging. How can such "hedging" turn a respectable gain into a loss that reduced book value? 

To answer that, we start with the basics. What is a variable annuity? It's a hybrid product which, after an investment period by the buyer, pays an income stream that usually varies with the market. Basically, it attempts the best of both worlds by giving income but more so when the equity market rallies. Insurers such as VOYA can invest initial proceeds in equity (funds) to match this potential liability. They can then add a margin for profits/cushion against potential mismatches.

At the same time, many variable annuities have a minimum return guarantee. If the market falls significantly, insurers may often still be on the hook for income. How can the insurer handle this? Investing in fixed income can provide relatively stable residual income, but in the current environment they can probably not buy enough. My hypothesis - invest more in equity but hedge with put options (and other derivatives such as variance swaps). In fact, VOYA has over-hedged:

That is why VOYA posted gains last Q2 (when equities fell) vs. a loss now.

How does this reconcile with the results? Yes, the loss was not insignificant, but from the most recent 10-Q (page 107), we see that persistently low interest rates increase the hedging costs for such variable annuities. VOYA also states that it focuses on capital adequacy vs. GAAP volatility.  Going forward, I'd like to see the swings diminish as the book runs off.

The next catalyst for GDX

I've been pretty negative on gold miners (GDX), both because of the perceived weak hands involved on the long side and the terrible capital allocation policies/rising breakeven costs of the miners. At the risk of falling into confirmation bias, the recent articles about renewed gold hedging could be the next catalyst for further gold weakness (this month's strength notwithstanding).

While the exact magnitude and effect of such selling may be difficult to predict, it is something that I believe will grow in intensity the longer gold stagnates and/or remains volatile. Taking the analogy of a new speculator who has taken multiple large illiquid long positions (and indeed higher forward buying), gold miners would rather not lock in mediocre profitability (or indeed loss) going forward. If the analogy holds, the components of GDX will hedge more if/as gold falls more as the pain grows, exacerbating the fall and creating that reflexivity that Soros speaks of.


To recap: miners have been slowly eliminating gold hedges as gold prices rise, perhaps exacerbating the rise itself.

(Source: http://www.gfms.co.uk/Market%20Commentary/SG-Hedge-Book/SG_GFMS_Global_Hedge_Book_Analysis_Q1_12.pdf.)

What if this tide turns? Given that marginal all in cash costs for the gold mining industry (which includes capex) is at roughly 1300/oz and growing, there is little room until losses. Cash costs ex capex (or variable cost, a la economics) at roughly 1100 is the level when firms theoretically stop production. But do they actually stop?

This is not to say that GDX will fall to new lows tomorrow - but there is a parallel here to prisoner's dilemma for gold miners. Given gold weakness over a year, the first ones to hedge above 1100-1300 will lock in okay results, but those who don't could see the effects of the first sellers...

 *Note to be fair: the effect of such selling is a key point that I haven't been able to figure out: when the quarterly volume of gold traded is in the billions of oz., millions don't seem too bad. Relative to annual production (50-100mm oz), those same millions do look sizable.


Disclosure: no position now, but intend to short GDX later this year

Are Emerging Markets Diversified?

GMO's most recent yearly forecasts seem like what most people think - negative on most bonds and most US equities, but most positive on emerging market equities (but interestingly, not their debt):

The traditional rationale for this is that emerging markets (Brazil, Russian India, China) are growing faster and will take a larger slice of the world economic pie going forward. More growth = more profits and more results for investors, right? It seems so obvious and straightforward, but how true is it?

First, emerging markets did outperform up to 2009:

However, looking at the composition of such indices, we see that up to 50%+ is essentially China (Taiwan, even Brazil because of commodity dependence):

As such, is emerging market investing essentially investing in China? Given the the relative short period (1-2 decades vs 1-2 centuries for the USA), are we assuming too much about emerging markets diversification?