PHDG Is Another Take On Low-Risk ETFs

December 08, 2012

A new ‘black-swan killer’ from PowerShares takes aim.

PowerShares’ launched a fund last week that offers an alternate take on off-the-shelf risk reduction, but how new is it?

The new fund, the PowerShares S&P 500 Downside Hedged Portfolio (NYSEArca: PHDG), aims at a particular type of risk reduction; namely, limiting the impact of major market downturns on performance.

This conjures up images of some kind of missile defense against “black swans.”

PHDG uses a derivative overlay to meet this ambitious goal. It dynamically allocates to futures on the CBOE Volatility index, aka the VIX. (I don’t mean to gloss over the word “futures,” and I’ll circle back to this later.) PHDG can even go to all cash when the you know what hits the fan.

This method of risk reduction stands in stark contrast to that of its hugely popular sister fund, the PowerShares S&P 500 Low Volatility ETF (NYSEArca: SPLV). SPLV and similar funds, such as the iShares MSCI USA Minimum Volatility Index Fund (NYSEArca: USMV) rely on stock selection to reduce risk, seeking out names with low volatility (SPLV) or low correlation (USMV).

The new fund, PHDG, meanwhile aims to match the returns of the S&P 500 Dynamic Veqtor Index. PHDG faces well-established competition in this respect: the Barclays S&P Veqtor ETN (NYSEArca: VQT) tracks the very same index.

PHDG offers an immediate advantage over VQT: a lower fee. PHDG costs 39 basis points versus VQT’s 95 basis points. PHDG’s ETF structure also eliminates the counterparty risk that’s baked into all ETNs: VQT is backed solely by the credit of its issuer, Barclays Bank.

Still, VQT brings real heft to the fight. It boasts assets of about $350 million and decent liquidity—7 basis points in bid/ask spreads on $2 million in average daily trading volume. The tradability in particular must be factored in when measuring all-in costs.

Brand-new funds like PHDG often trade at wide spreads, which means the two products’ all-in costs are closer than the headline fee difference implies.

VQT has another edge: tracking. As an ETN, it essentially delivers the returns of its index perfectly, less its admittedly huge fee. PHDG has the normal tracking disadvantages of an ETF, plus one more: It's actively managed.

The fund clearly aims to match the index’s returns, not beat them, so its “active” designation is a bit odd until one considers the recent SEC ruling allowing derivatives in new active funds only.

Perhaps the timing is coincidental, but the bottom line is that PHDG will show more tracking volatility than VQT, even if it tries to have it both ways by claiming zero tracking error as an active fund.


Enough with the esoterica. Does this black-swan killer really work? And if so, what’s the cost in upside?

Obviously we don’t have performance data on shiny new PHDG, but the index underlying both PHDG and VQT—the S&P 500 Dynamic Veqtor Index—makes a great reference to examine. I chose VQT’s inception date of Aug. 21, 2010 as a starting point, and the chart ends at Dec. 6, 2012.

This period includes a black swan of sorts in the form of Standard & Poor’s ignominious downgrade of U.S. debt in August 2011, an event marked by the sharp drop of the S&P 500 index, shown here in dark blue.


SP500 vs PHDG Index



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