First Trust CBOE S&P 500 VIX Tail Hedge Fund (VIXH) began trading yesterday (8/30/12). The underlying CBOE VIX Tail Hedge Index is based on the S&P 500 and an amount of one-month call options on the VIX Index, ranging from 0% to 1% of the portfolio. The exact amount is determined by the level of forward volatility.

Black swan events are defined to be those that are both a surprise and have a major impact. In statistical terms, they are often referred to as 3-sigma (three standard deviations) events, and more recently the term “tail risk” has been used in financial circles. VIXH’s objective is to hedge away the tail risk of equity exposure.

According to the VIXH overview page, on the day of the monthly expiration of VIX options, previously purchased VIX calls are cash-settled and new VIX calls are purchased by the index at the 10:00 am Central Time asking price. The percent of money allocated to VIX calls depends on the level of forward volatility of the S&P 500 at the next call expiration as measured by the opening price of VIX futures with the same expiration as the calls as follows:

  • VIX futures less than or equal to 15, no VIX calls are purchased
  • VIX futures above 15 and less than or equal to 30, 1% of portfolio in VIX calls
  • VIX futures above 30 and less than or equal to 50, 0.50% of portfolio in VIX calls
  • VIX futures above 50, no VIX calls are purchased

The dynamic allocation to VIX calls is designed to reduce hedging costs by limiting the number of VIX calls that are purchased during periods of expected low volatility. It also has the effect of taking VIX option profits when extreme volatility levels are reached.

VIXH is holding all 500 stocks of the S&P 500, in the appropriate allocations. The new ETF has an expense ratio of 0.60%, and additional information is located in the fact sheet (pdf) and prospectus (pdf).

Analysis/Opinion: I have long held the belief that exposure to the VIX provides an excellent way of reducing risk in an equity portfolio and addressed that topic in my 2009 article New ETNs Allow You to Buy Volatility: VXX, VXZ. Unfortunately, no products are available that track the VIX. Instead, traders and investors must be content with VIX futures and options, which have their own unique characteristics. The new VIXH uses VIX call options.

With an upper range of 1% per month, the performance impact of constantly hedging at the maximum level could be significant. In order to potentially control hedging costs, the underlying index and VIXH reduce hedging to 0.5% when the VIX is between 30 and 50. Additionally, no hedging is used when VIX is below 15 or above 50.

To me, the fact that VIXH is not constantly hedged is a significant drawback, bordering on absurdity. I am not a career statistician, but I think this makes VIXH vulnerable to future black swan events rather than protecting investors from them. The VIXH Investor Guide (pdf) identifies only five black swan events in the past 25 years. In other words, the sample size is much too small to be meaningful. Additionally, a black swan event is by definition a “surprise” event. To claim that the element of surprise, and the associated portfolio impact, is nonexistent much of the time based on only five observations over 25 years tends to stretch statistical credibility.

Although the official expense ratio is 0.60%, the actual cost to shareholders is likely to be much higher. The fund may have to sell a portion of each of its 500 stocks every month in order to free up cash for additional VIX call options. It also intends to reinvest every dividend received on those 500 stocks. The transaction costs (brokerage fees and slippage) on up to 6,000 transactions per year (much more if you include dividend reinvestments) could have a severe performance impact. Hopefully, the management team has considered the cost of implementing this strategy with individual stocks versus using Vanguard S&P 500 (VOO) for the equity exposure.

Potential investors of VIXH should compare to Barclays ETN+ S&P VEQTOR ETN (VQT) before buying.