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Which Volatility Hedged ETF Should You Consider?

VIXH VQT

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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 (read 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 ETFs that investors can take advantage of, especially if the markets turn south post the debt ceiling debate and/or yet another sour earnings season.

First Trust CBOE S&P 500 VIX Tail Hedge ETF (VIXH - ETF report)

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.

Strategy

The ETF seeks to hedge the tail risk (i.e. the outliers that fall beyond plus/minus 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 volatility.

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 markets (read 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.

The Barclays S&P 500 Dynamic VEQTOR ETN (VQT - ETF report) 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.

Strategy

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 upside potential.

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