First Trust Advisors has launched a new exchange-traded fund, First Trust CBOE S&P 500 VIX Tail Hedge Fund.
A tail hedging strategy, which tries to protect a portfolio from extreme market swings resulting from unpredictable, random and unexpected events (also known as “black swans”), will be used.
This methodology may help the fund hedge against such developments and hopefully offset some of the losses in the common stock portfolio due to the unexpected events.
The CBOE VIX Tail Hedge Index, a benchmark index created by Chicago Board Options Exchange (CBOE), tracks the performance of each equity security in the S&P 500 Index (with dividends reinvested) and allocates a variable percentage to a long position in a call option on the CBOE Volatility Index (VIX).
The index is reconstituted and rebalanced every month. At the time of the index rebalancing, the amount allocated to the call option varies between zero per cent and one per cent, with the balance of the index being invested in an S&P 500 stock portfolio. During periods of extreme volatility, the out-of-money call options on the VIX index may generate large positive returns that offset losses in the common stock portfolio; however, there is no guarantee that the tail hedge will be effective in offsetting any of the losses in the index’s allocation to the S&P 500 stocks.
In order to reduce hedging costs, the index (and the fund) varies the weight of the VIX calls at each monthly rebalance. The weight of the VIX calls is dependent upon expected levels of forward volatility as measured by the VIX futures curve. At low levels of expected volatility (<15 per cent) or extremely high levels of expected volatility (>=50 per cent), no call options are purchased and their respective weight is zero per cent. At levels greater than or equal to 15 per cent, but less than 30 per cent, one per cent of the portfolio is allocated to call options. At levels greater than or equal to 30 per cent, but less than 50 per cent, 0.5 per cent of the portfolio is allocated to call options. If an allocation is made to the “tail hedging” strategy at the monthly rebalance date, the VIX call options are held through the expiration date the following month, at which time the index is reconstituted and rebalanced.
“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,” says Robert Carey, chief market strategist of First Trust. “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.”