We live in a funny world. Just about a month ago, almost
everybody was talking about a major downtrend in the equity
markets anticipating a drop off the fiscal cliff.
And here we are, comfortably sitting at a 4% rally across the
equity markets in the first couple weeks of 2013.
However, the build-up to this rally has been one of the most
heart stopping events that investors have witnessed for a very
long time. With markets remaining 'choppy' for a decent half of
December ahead of the fiscal cliff deal, most investors found
refuge in the 'wait and watch' game. And rightly so, as the
markets demanded caution until the deal was finalized. Finally,
now that we have some clarity over the fiscal cliff deal,
hopefully the markets can trend upwards for at least sometime now
Zacks Top Ranked Low Volatility ETF in Focus
Nevertheless, uncertainty and investment are synonymous. They
have always been so. First we had the Eurozone uncertainty, then
the fiscal cliff uncertainty and now we are poised for yet
another 'debt ceiling' uncertainty ahead, which if unresolved,
could lead to a sovereign credit rating downgrade for the United
States (which was the case in 2011 during the first downgrade)
and upset the capital markets.
However, that is where the art of investing lies.
Understanding and respecting each market condition and acting
accordingly is the remedy for surviving in any market condition.
This is where investment decisions should be based more on logic
and less on emotions.
And logic does surely tell us that although the markets will
enjoy a relief rally for the subsequent few trading sessions,
they will continue to remain choppy (not bearish) as we approach
the debt ceiling debate (read
The Best Investing Style ETF This Fiscal?
Furthermore, as we are in the midst of yet another earnings
season, one thing is certain. The fundamentals on the corporate
earnings front have to improve for the markets to achieve new
highs in the new fiscal year. This is especially important after
the subdued earnings performance reported by corporate America in
the third quarter of this fiscal.
With this backdrop we take a look at some volatility hedged
that investors can take advantage of, especially if the markets
turn south post the debt ceiling debate and/or yet another sour
First Trust CBOE S&P 500 VIX Tail Hedge ETF (
The four month old ETF seeks to replicate the performance of
the CBOE VIX Tail Hedge Index with a primary objective of
reducing exposure to volatility. Since its inception, the ETF has
been able to amass an asset base of just $2.96 million charging
investors a relatively paltry 60 basis points in fees and
expenses. This is especially true considering the innovative
strategy employed by the fund managers. On an average only 5,300
shares of VIXH are traded each day.
The ETF seeks to hedge the tail risk (i.e. the outliers that
three standard deviations from the mean of the implied volatility
distribution curve) by taking exposure in the equities that
comprise the S&P 500 index and front month Volatility Index
(VIX) call options.
The tail risk hedge takes care of extreme market volatility
which can potentially result in a crash. Therefore these events
are considered to be outliers which normally do not fall within
three standard deviations of the average of the implied
The Volatility Index and the S&P 500 basically have a very
strong negative correlation. Therefore, to hedge against the
S&P 500 volatility, the ETF takes a long position in VIX Call
options (i.e. buying the right to buy the VIX at a predetermined
price). This indirectly implies betting against the equity
Time to Invest in Low Volatility ETFs?
So at one end we have long VIX Calls (in anticipation of a
stock market downturn) and on the other end we have long S&P
500 (in case the market doesn't fall). Therefore this causes the
hedge to be obtained successfully.
Of course the allocation to S&P 500 and the VIX options
would depend on the anticipated volatility in the near term. And
the fund managers have a predetermined slab which
specifies the equity and volatility allocation
depending on the level of VIX Futures. During expiry the call
options are rolled over to the subsequent month.
Although it is still early days for the ETF and little can be
made out of its performance thus far, it might well be a winning
bet during a severe market slump.
Barclays S&P 500 Dynamic VEQTOR ETN (
is another option available to the investors to access a
volatility hedge. The ETF was launched in September of 2010 and
tracks the S&P 500 Dynamic VEQTOR Total Return Index. The
index utilizes stocks, volatility and cash to achieve its
underlying objective of generating equity market returns with
negligible levels of volatility.
The ETF can be considered quite pricey as it charges an
expense ratio of 95 basis points. Nevertheless, VQT should be a
good choice for investors seeking protection. It does not pay out
any yield and on an average nearly 26,000 shares of VQT are
traded each day.
Unlike its counterpart VIXH which seeks to hedge volatility by
using VIX options, VQT uses Volatility Futures contracts directly
to hedge volatility. The ETF increases allocation to the equity
component as measured by the S&P 500 Total return index, in
times of low volatility,. It increases volatility exposure as
measured by the S&P 500 VIX Futures Total Return index and
allocates entirely into cash if the index slumps more than or
equals 2% in the preceding 5 days (read
Gold ETFs: Is the Sell-Off Overdone?
In this manner the ETF manages to keep a check on volatility
and as suggested by an annualized standard deviation of 9.48% it
has been fairly successful in doing that. This is especially true
if one considers the equity market volatility of 18.71% for the
same time period.
The ETF also maintains substantial transparency with investors
as it has a predetermined plan to switch over allocations to
equity and volatility depending on the market scenario at that
given time. The following table
from the website of Barclays Capital
summarizes the target allocations.
It is true that the volatility hedged ETFs can prove to be
great sources when it comes to protection against a market
downturn. However, apart from enhancing protection to the
investors, the volatility hedged ETFs have very limited utility
as the hedging strategies used by the ETFs severely limit their
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FT-CBOE SP5 VIX (VIXH): ETF Research Reports
BARCLY-SP VEQTR (VQT): ETF Research Reports
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