As markets continue to oscillate in a narrow range, many investors are starting to wonder which way stocks will trend next. Some are looking for equities to test new highs as uncertainties from the presidential election, geopolitical worries, and a resolution to the European crisis all wither away and allow investors to buy up stocks in droves.
Meanwhile, other investors are looking for a sharp drop in stocks thanks to any number of events in the marketplace. These still unlikely to happen events could come in the form of some sort of bout with Iran, an unexpected exit in the euro zone, or even a further slowdown in emerging markets that truly calls into question the global growth story (read Six Easy Ways to Target Low Volatility Stocks with ETFs).
However, while any of these events could send the market sharply lower in short-order, the chances of any of them happening are very slim. Still, all of these risks are out there in the market and investors need to be at least somewhat prepared for these issues, or any other ‘black swans’ striking the market.
In light of this, and what seems to be the relative frequency with which these black swan events hit the market (at least three in the past 15 years), it could be time to position portfolios accordingly. For these investors, First Trust’s new fund could be worth delving into more closely, especially for those who feel that they don’t have enough protection against ‘tail risk’ events (read Is it Time for an Equal Weight ETF?).
VIXH in focus
First Trust’s new ETF, the S&P 500 VIX Tail Hedge Fund (VIXH), looks to mitigate tail risk worries–or events that happen outside of three standard deviations from the norm–by investing in both the S&P 500 and VIX call futures. This is done by targeting the CBOE VIX Tail Hedge Index which is a benchmark that offers exposure to both of these asset classes.
In essence, this benchmark will invest in the broad S&P 500 securities and a variable amount of one-month call options on the VIX index, based on forward volatility levels. On the monthly rebalancing date, VIXH’s managers take a look at the VIX and if the benchmark is less than 15 or greater than 50, no calls are purchased (see Three Low Volatility ETFs for Stormy Markets).
However, if the VIX futures are above 15 and lower than 30, 1% of the portfolio will be devoted to VIX calls, while if the futures are above 30 and less than 50, 0.50% of the portfolio is put into VIX calls. These calls are purchased by the index at 10am CT on the rebalancing date while the old contracts are cash settled as well. For this exposure, VIXH charges investors 60 basis points a year in fees, making the fund relatively inexpensive considering the type of exposure offered.
“The lesson of the 2008 global financial crisis is that a single severe market shock can devastate entire portfolios and wipe out many years of market gains,” said Robert Carey, CFA, Chief Market Strategist of First Trust in a press release. “Given the surge in interest in tail risk and tail risk hedging in the wake of that crisis, we believe this is an ideal time to launch a Fund offering long-term investors a convenient way to attempt to hedge against the risk of similar extreme market events.”
Strategy Explained
First Trust seems to believe that deep market declines, based on their research, have rarely occurred at very low or very high levels of expected volatility, which is why they refrain from buying VIX calls at both of those extremes. Furthermore, since the VIX has an extremely low negative correlation with broad equity markets, it is the perfect hedge for ‘black swan’ events that hit the broad markets during moderately volatile time periods (read Three Defensive ETFs for a Bear Market).
This is especially true given the call option approach that VIXH uses in order to achieve its VIX exposure. Calls allow for maximum exposure with a minimum dollar investment, making them great ways to obtain VIX exposure while still keeping the vast majority of the portfolio in equities.
ETF Competition
VIXH is a relatively unique fund from First Trust, although it will likely face at least some competition from at least a few other funds out there. Arguably, the biggest competitor looks to be from iPath in their S&P VEQTOR ETN (VQT).
This product uses a similar technique to protect against tail risk issues, cycling between cash, the S&P 500 and the VIX. However, this note focuses in on realized volatility levels and pushes more into the short-term VIX as the level of realized volatility increases, up to 40% in the VIX under certain, extreme circumstances.
It should also be noted that VQT is structured as an ETN, so it has some of the credit risk from Barclays, but it will not have any tracking error, unlike its ETF counterparts. However, investors have to pay for this exposure, as the fees come in at 95 basis points a year, more than double VIXH (see more in the Zacks ETF Center).
Still, VQT is quite popular with investors as the product has over $350 million in assets and sees trading volumes approaching 50,000 shares a day. With these figures, it is pretty clear that First Trust sought to launch a new competitor in the space in order to hopefully steal away some of this impressive total from iPath.
While it will be a hard road for First Trust’s new fund, especially initially launching before a three day weekend, the fund could see some inflows from investors looking to hedge against tail risks while still staying in the ETF (as opposed to the ETN) world. Furthermore, the costs for VIXH are far lower than its iPath counterpart, and the VIX call allocation is very intriguing, suggesting that for those investors worried about black swans, the new fund could be worth a closer look.
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