My colleagues recently provided an overview of the new fund. So now I want to underscore a few key points and then look at performance.
Instead, VIXH aims to deliver one-stop shopping for a basket of U.S. stocks that also includes some protection against major downside risk.
In other words, the fund is designed to replace medium- to long-term U.S. equity positions with an equity-plus-derivative overlay.
Specifically, VIXH holds a basket of S'P 500 stocks, but it adds something extra. To protect against major downturns, the fund also buys options on the VIX index.
The idea is that the VIX—sometimes referred to as the fear index—goes up when disaster strikes. The value of the options will increase if the VIX goes up, providing a hedge to offset the loss from the stocks in the portfolio.
How Do The Options Work?
First, the fund will at times take no options position when the VIX—or, more accurately, front-month VIX futures—are very high or very low. Still, the fund’s index has had VIX options exposure over most of the past five years and all of the past three years, according to the CBOE, which runs the fund’s index.
Second, the options position, when active, varies with the level of front-month VIX futures. The fund buys one-month, cash-settled, out-of-the-money call options with a delta or sensitivity to the underlying of 0.3.
The key takeaway from the options overlay is this:The fund pays for this exposure most of the time in the hopes that it will pay off big when it’s needed most. The downside is that buying calls costs money, just like a premium on an insurance policy, and these premiums are a drag on returns.
Does It Work?
VIXH launched last Wednesday, so we’ll have to rely on a comparison of its index (VXTH) to the S'P 500 index (SPXT). Both are total return indexes. Indexes ignore fees, which gives an edge to VIXH for our analysis.
You’d expect that VIXH’s index would do well over the last five years that include the fall 2008 meltdown and S'P’s nadir in March 2009. Indeed VIXH’s returns (in blue) look good here, relative to the S'P (in gray), at 21.1 percent vs. 4.9 percent, respectively.
But what about over the past three years, where the S'P has gained 49.3 percent? I’d expect a structure that buys insurance against downside in an up market to suffer. And, indeed, VIXH’s index lags, with a return of 43.7 percent. However, it drags less than I’d expected.
Still, the closeness of the period return belies how different the pattern of returns really is. I get an r-squared of only 0.64 when I regress VIXH’s index returns on those of the S'P. This low figure means the unhedged market returns don’t explain that much of VIXH index returns.
Over one year, the VIXH index returned only 6.5 percent vs. the S'P’s 18.8 percent. It’s not at all clear to me why these relative results differ from the three-year period.
Next Gen or Me-Too?
VIXH’s closest competition is the Barclays ETN+ S'P Veqtor ETN (VQT).
VQT dynamically combines equity and volatility exposure as VIXH does. But VQT gets volatility exposure from VIX futures rather than VIX options. And VQT’s volatility-exposure mechanism is more complex in that it also looks at the recent volatility in the S'P 500.
VQT also has the capacity to move to all cash exposure.
So VIXH is not a next-generation product:VQT already offers a dynamic equity and volatility combo. But VIXH isn’t a me-too product since its rules and its exposure differ materially from VQT’s.
The one- , three- and five-year returns for the indexes under these two products differ significantly too, though that’s a topic for another day.
No doubt VIXH would have offered some protection against the worst of the financial crisis. But I have a harder time explaining the more recent results.
The options overlay has a profound impact on returns, not one that just magically clips the low points. (Such a beast – with low beta in down markets and high beta in up markets—is as rare as the unicorn).
I like the basic idea of using an overlay to tame risk. But is VIXH’s overlay anywhere near the best possible in an ETF wrapper? Would altering the trigger, weight or delta of the options make it better? Are options on the VIX even the right tool for a hedge? And are such overlays best applied by rule or as a judgment call?
I can’t answer yes to these questions without some major research. So I look forward to watching VIXH, but from the sidelines.
At the time this article was written, the author had no positions in the securities mentioned. Contact Paul Britt at email@example.com .
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