My colleagues recently provided an overview of the new fund. So
now I want to underscore a few key points and then look at
performance.
First, the First Trust CBOE S&P 500 Tail Hedge Fund
(NYSEArca:VIXH) is emphatically not a short-term, high-octane
volatility product like the iPath S&P 500 VIX Short-Term
Futures ETN (NYSEArca:VXX).
Instead, VIXH aims to deliver one-stop shopping for a basket of
U.S. stocks that also includes some protection against major
downside risk.
In other words, the fund is designed to replace medium- to
long-term U.S. equity positions with an equity-plus-derivative
overlay.
Specifically, VIXH holds a basket of S&P 500 stocks, but it
adds something extra. To protect against major downturns, the fund
also buys options on the VIX index.
The idea is that the VIX-sometimes referred to as the fear
index-goes up when disaster strikes. The value of the options will
increase if the VIX goes up, providing a hedge to offset the loss
from the stocks in the portfolio.
How Do The Options Work?
First, the fund will at times take
no
options position when the VIX-or, more accurately, front-month VIX
futures-are very high or very low. Still, the fund's index has had
VIX options exposure over most of the past five years and all of
the past three years, according to the CBOE, which runs the fund's
index.
Second, the options position, when active, varies with the level
of front-month VIX futures. The fund buys one-month, cash-settled,
out-of-the-money call options with a delta or sensitivity to the
underlying of 0.3.
The key takeaway from the options overlay is this:The fund pays
for this exposure most of the time in the hopes that it will pay
off big when it's needed most. The downside is that buying calls
costs money, just like a premium on an insurance policy, and these
premiums are a drag on returns.
Does It Work?
VIXH launched last Wednesday, so we'll have to rely on a
comparison of its index (VXTH) to the S&P 500 index (SPXT).
Both are total return indexes. Indexes ignore fees, which gives an
edge to VIXH for our analysis.
You'd expect that VIXH's index would do well over the last five
years that include the fall 2008 meltdown and S&P's nadir in
March 2009. Indeed VIXH's returns (in blue) look good here,
relative to the S&P (in gray), at 21.1 percent vs. 4.9 percent,
respectively.
Over one year, the VIXH index returned only 6.5 percent vs. the
S&P's 18.8 percent. It's not at all clear to me why these
relative results differ from the three-year period.
.%3C/p%3E%0A%3Cp%3EVQT%20dynamically%20combines%20equity%20and%20volatility%20exposure%20as%20VIXH%20does.%20But%20VQT%20gets%20volatility%20exposure%20from%20VIX%20futures%20rather%20than%20VIX%20options.%20And%20VQT%E2%80%99s%20volatility-exposure%20mechanism%20is%20more%20complex%20in%20that%20it%20also%20looks%20at%20the%20recent%20volatility%20in%20the%20S&P%20500.%3C/p%3E%0A%3Cp%3EVQT%20also%20has%20the%20capacity%20to%20move%20to%20all%20cash%20exposure.%3C/p%3E%0A%3Cp%3ESo%20VIXH%20is%20not%20a%20next-generation%20product:VQT%20already%20offers%20a%20dynamic%20equity%20and%20volatility%20combo.%20But%20VIXH%20isn%E2%80%99t%20a%20me-too%20product%20since%20its%20rules%20and%20its%20exposure%20differ%20materially%20from%20VQT%E2%80%99s.%3C/p%3E%0A%3Cp%3EThe%20one-%20,%20three-%20and%20five-year%20returns%20for%20the%20indexes%20under%20these%20two%20products%20differ%20significantly%20too,%20though%20that%E2%80%99s%20a%20topic%20for%20another%20day.%3C/p%3E%0A%3Cp%3E%3Cstrong%3ESumming%20Up%3C/strong%3E%3C/p%3E%0A%3Cp%3ENo%20doubt%20VIXH%20would%20have%20offered%20some%20protection%20against%20the%20worst%20of%20the%20financial%20crisis.%20But%20I%20have%20a%20harder%20time%20explaining%20the%20more%20recent%20results.%3C/p%3E%0A%3Cp%3EThe%20options%20overlay%20has%20a%20profound%20impact%20on%20returns,%20not%20one%20that%20just%20magically%20clips%20the%20low%20points.%20(Such%20a%20beast%20%E2%80%93%20with%20low%20beta%20in%20down%20markets%20and%20high%20beta%20in%20up%20markets%E2%80%94is%20as%20rare%20as%20the%20unicorn).%3C/p%3E%0A%3Cp%3EI%20like%20the%20basic%20idea%20of%20using%20an%20overlay%20to%20tame%20risk.%20But%20is%20VIXH%E2%80%99s%20overlay%20anywhere%20near%20the%20best%20possible%20in%20an%20ETF%20wrapper?%20Would%20altering%20the%20trigger,%20weight%20or%20delta%20of%20the%20options%20make%20it%20better?%20Are%20options%20on%20the%20VIX%20even%20the%20right%20tool%20for%20a%20hedge?%20And%20are%20such%20overlays%20best%20applied%20by%20rule%20or%20as%20a%20judgment%20call?%3C/p%3E%0A%3Cp%3EI%20can%E2%80%99t%20answer%20yes%20to%20these%20questions%20without%20some%20major%20research.%20So%20I%20look%20forward%20to%20watching%20VIXH,%20but%20from%20the%20sidelines.%3C/p%3E%0A%3Chr%20/%3E%0A%3Cp%3E%3Cspan%20style='font-style:italic;'%3EAt%20the%20time%20this%20article%20was%20written,%20the%20author%20had%20no%20positions%20in%20the%20securities%20mentioned.%20Contact%20Paul%20Britt%20at%20%3C/span%3Epbritt@indexuniverse.com%3Cspan%20style='font-style:italic;'%3E.%3C/span%3E%3C/p%3E%0A%3Cp%3E%C2%A0%3C/p%3E%3Cdiv%20id='permalink'%3EPermalink%20%7C%20'copy;%20Copyright%202009%20IndexUniverse%20LLC.%20All%20rights%20reserved%3C/div%3E%3Cp%3E%3Ca%20href=)
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