Downside Risk ETFs Get Their Moment

October 15, 2014

Equity ETFs that rely on VIX derivatives to hedge downside risk yield a surprising range of results.

Today continues a crimson-tinged trend: Another day of extreme market volatility in the downward direction after a long period of relative tranquility.

This drama got me wondering about the small batch of equity funds specifically designed to weather such storms by profiting from volatility.

These ETFs use futures or options on the CBOE volatility index, known as the VIX index or simply as the fear index. By incorporating VIX exposure via derivatives—a tool set that’s notoriously hard to handle—the ETFs aim to provide downside protection from sharp downturns like those we’ve seen recently, while maintaining broad equity exposure.

Before we look at the short-term performance of these funds, let’s check what the VIX index itself has been doing since the start of September against the S&P 500 and a leading VIX-based fund.

VIX VXX SPXT

It’s up more than 85 percent. Sadly, the fear index is uninvestable. The next best thing for direct access to this high-octane contrarian is the iPath S&P 500 VIX Short-Term Futures ETN (VXX | A-47). VXX is up about 34 percent for the same period—a nice counterpoint the S&P 500 Index’s 6 percent drop.

VXX uses derivatives to access the VIX, just as the tail-risk-hedged ETFs do. The key difference is that the tail-risk-hedged products also have baseline exposure to equities and use a VIX derivatives overlay to get upside from any downdraft.

 

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