Is the ETF world ready for another pair of volatility overlay strategies? How about another covered-call strategy?
Ready or not, here they come. Three new funds launched Monday, all using the S'P 500 as a starting pointing and blending in derivatives to achieve a stated goal.
Derivatives. Stated in generic form, the word sounds pejorative. But the fund issuers here use derivatives overlaid on the S'P 500 as a force for good, not evil—or they try to, anyway.
The derivative angle here is risk reduction, with an emphasis on protecting against a string of big, bad down days.
The funds use a complex combination of long and short exposure to VIX futures that make up 15 percent of the portfolio, with the S'P 500 comprising the remaining 85 percent. The long VIX futures element will help when markets tank, as they did last Thursday. The short VIX futures exposure is there to offset the brutal position decay from contango in the VIX futures.
The strategy comes in two flavors:neutral and long volatility. Neutral SPXH aims for offsetting volatility exposure using one-third 2x volatility and two-thirds -1x volatility. Long-vol TRSK uses the same building blocks, but skews the exposure toward a targeted 35 percent net long-vol position.
A clarifying point regarding derivatives:The fund’s indexes get volatility exposure not from derivatives but from other ETFs—namely geared funds from ProShares. The fund itself, however, will rely on swaps for this exposure. Frankly, the exact vehicles matter far less than the mashup of exposures.
But let’s face it, these funds peg the complexity meter. Investors in either of these products need to understand the VIX, VIX futures and contango, geared exposure and long/short strategies.
Most mortals won’t grasp how all of these moving parts are likely to work in concert. I freely admit I don’t. Given the asymmetric returns associated with the elements at work here, I’d probably want to see 400 years of returns data to have some confidence.
I will say this, however. VIX futures products like VXX are building blocks with extremely sharp edges.
VXX trades something like $500 million to $1 billion a day—and loses about 75 percent annually. The folks at VelocityShares have said for years that people shouldn’t use products like VXX in a vacuum, but instead as part of a comprehensive strategy. And they’ve offered up some here—each for 71 basis points a year. Somebody somewhere is probably paying 2-and-20 for similar exposure in a hedge fund and is forgoing liquidity, to boot.
Note that SPXH and TRSK compete directly with the First Trust CBOE S'P 500 VIX Tail Hedge ETF (VIXH). VIXH launched in August 2012 and uses call options on the VIX for its tail-hedging mojo. It lacks the negative-vol component, so it’s less complex, but it forgoes any means to offset the cost of the calls’ premiums.
Monday’s third launch, the Horizons S'P 500 Covered Call ETF (HSPX), uses derivatives overlaid on the S'P 500 with a different aim entirely:income.
In short, the fund sells call options (backed by the underlying stocks), pockets the premium and hopes the calls expire worthless as they would if the underlying stock prices don’t go up too much.
The strategy is hardly new, even in ETF form. Two products on the market for years have delivered a covered-call take on the S'P 500:the PowerShares S'P 500 BuyWrite ETF (PBP) and the iPath CBOE S'P 500 BuyWrite ETN (BWV).
PBP’s and BWV’s strategies differ a bit in that they focus on options that are at-the-money (higher delta). This approach yields higher premiums for the options sold but forgoes more upside in an equity rally. In contrast, Horizons’ HSPX has a bias toward out-of-the-money options (lower delta) that command a lower premium, but the fund retains more upside if the S'P 500 rises.
While lower premiums don’t sound appealing, HSPX holds a clear edge for income seekers:monthly distribution. In contrast, PBP pays quarterly, and BWV makes no distributions as an ETN.
The three new funds here use derivatives to modify equities for specific purposes. They pass up the ETFs-as building-blocks approach in favor of an off-the-shelf, one-stop solution.
Call me a voyeur—I like to see strategies like these launch and monitor how they do. But I can’t imagine investing in SPXH or TRSK. They’re too complex for me. HSPX is closer to my comfort zone if I were income-inclined.
In the end, however, I say hold the side orders. My preferred diet consists of plain vanilla—pure beta, liquid and cheap—served up by a guy behind the counter who looks a lot like Jack Bogle.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at firstname.lastname@example.org.
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