The fourth quarter GDP number witnessed a minute shrink of -0.1%, however, little did it contribute in underwhelming the mood of the stock market. Investors probably realize that the shrinkage was just another aftermath of Superstorm Sandy rather than weakening economic fundamentals of the nation.
Further recent trade deficit data and the decline in wholesale inventories suggest that the GDP data will likely be revised upwards.
With corporate earnings season proving to be better than expected and other economic data showing signs of a positive momentum, the equity markets seem to be poised for further upmove from current levels, even though the markets did take a slight dip yesterday after the release of the FOMC minutes. (read 3 Ways to Play the S&P 500 Rally with ETFs).
There are a number of products in the exchange traded products (ETPs) space that enable investors to gain exposure in the broader equity markets in order to take advantage of this situation. However, choosing from these options require a thorough understanding of their investment strategies and risks involved. These products should be analyzed keeping in mind one’s own risk return tradeoff before any investment decisions.
In the light of the above, we would like to highlight two such products that provide an exposure to the S&P 500. However, their strategies differ substantially from other products offering similar exposure. Also, these products are derived from volatility, naturally these products demand a steady appetite for risk (read 3 ETFs at the Heart of The Recent Rally).
Short volatility ETFs in a way provide a long (i.e. positive) exposure to the S&P 500 Index. Since the Volatility Index (VIX) measures the expected (implied) volatility that the S&P 500 is going to witness in the next 30 days, the movements of the VIX and the S&P 500 are inverse in nature. And naturally, any product that bets against the VIX will surely provide a long exposure to the S&P 500.
The Short VIX Short Term Futures ETF (SVXY - ETF report) and the VelocityShares Daily Inverse VIX Short Term ETN (XIV - ETF report) are two such ETFs. In fact these two ETFs have a very high correlation of more than 80% with the S&P 500. Naturally, such high correlation suggests that these two ETFs certainly do bear a direct relationship with the S&P 500 Index.
These two ETFs are very similar in terms of their investment objectives and strategies. They provide inverse daily exposure to the spot VIX level by taking exposure in the volatility futures contracts. The ETFs seek to provide a daily rolling short position in the immediate first and second month of VIX futures contracts. The contracts are rolled over on a daily basis (see Volatility ETFs: Three Factors Investors Must Know).
While the strategy looks complicated, the underlying explanation is very clear. These ETFs thrive when the market sentiment is upbeat and the fear level is low. This situation reduces the implied volatility in the market which in turn helps these ETFs to post significantly high returns.
Furthermore, the ETFs’ short term focus helps it them magnify gains further since the short term future contracts are more sensitive to contango. Yet for a change, contango which is considered to be the biggest worry for futures backed products is actually helping them.
This is especially true considering two very important factors 1) the inverse nature of these products, coupled with 2) A heavy contango across volatility futures curve due to the broader market surge of late. These two factors along with the short term focus have resulted in a terrific run for these two ETFs.
The chart above represents one year comparative performance of three products (including SVXY and XIV) which can be utilized by investors to bet on the S&P 500 uptrend. The other product is the SPDR S&P 500 ETF (SPY - ETF report) which tracks the S&P 500 Index directly.
Not surprisingly, the inverse VIX ETFs have outperformed SPY by an unbeatable margin. This disparity in returns has been due to the daily rebalancing technique of the inverse VIX ETFs coupled with the contango effect. Over the last one year XIV and SVXY have returned 150% and 146.30% respectively, compared to SPY returning 14.02% (see Three Surging ETFs with Strong Momentum).
However, these inverse volatility ETFs are not meant for everyone. These products are vulnerable even to the slightest movements in the underlying market. The annualized standard deviations for these two products are around 69% each which shows that these products are extremely volatile in nature. Nevertheless, for well informed investors having an above par risk tolerance, these two ETFs can surely be a fantastic bet.
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