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.
Sure enough, the light blue S&P 500 Dynamic Veqtor Index spikes upward during the downgrade event, more than erasing the 17 percent by which it lagged the S&P up to that time.
But the holding period return over the whole range from VQT’s inception through Dec. 6, 2012 highlights the downside of downside hedging: The S&P 500 beats the S&P 500 Dynamic Veqtor Index by about 9.9 percentage points. I’d guess that without the August 2011 event , this difference would have been even more dramatic.
The point is that this sophisticated risk mitigation technique appears to come with an utterly unsurprising catch: significant underperformance in up markets.
A second chart adds the performance of the VIX index in dark gray and VIX futures in light gray.
The first point here is that VIX futures track the VIX poorly over time, and generally lead nowhere but down in the long run. The S&P 500 Dynamic Veqtor Index has exposure to VIX futures, not to the VIX itself, which is uninvestable.
The saving grace is the “dynamic” in the S&P 500 Dynamic Veqtor Index—it does not maintain a large fixed weight in VIX futures. Still, anyone consider either PHDG or VQT needs to have some inkling of how VIX futures perform.
In the end, I’m guessing that PHDG will offer some protection against major market upsets, just as VQT has done to-date.
As for PHDG versus VQT, I’d look hard at the spreads and your intended holding period before deciding if PHDG’s lower fee really pays off, and don’t forget the age-old counterparty risk versus tracking issue for VQT.
If I had to invest in one of them soon, I’d stick with VQT until fledgling PHDG gets some traction.
At the time this article was written, the author had no positions in the securities mentioned. Contact Paul Britt at [email protected].