ALPS Plans High-Volatility ETF

January 20, 2012

With the market rising, is it time to chase some alpha with the new volatility ETF ALPS has in the works?

ALPS, the Denver-based exchange-traded fund sponsor known as one of the first firms to actively market ETFs, filed paperwork with the Securities and Exchange Commission to market a new high-volatility ETF that will track an index of a hypothetical portfolio comprising exchange-traded put options.

The U.S. Equity High Volatility Put Write Index Fund will be listed on Arca, the New York Stock Exchange’s electronic trading platform under the symbol “HVPW,” and will have an annual expense ratio of 0.95 percent, according to the filing. The fund will be ALPS's fourth ETF.

With the market’s recent upswing, HPVW might be going into registration at a propitious time. High-volatility stocks generally experience significant declines in a bear market, but when stocks are rallying, high-volatility stocks can experience greater gains.

Although low-volatility ETFs, such as the PowerShares S&P Low Volatility ETF (NYSEArca: SPLV), have been popular since they came on the scene last spring, the high-volatility ETF landscape is more limited. HVPW is joining a field that is dominated by several Russell funds, including the Russell 1000 High Volatility Fund (NYSEArca: HVOL) and the Russell 2000 High Volatility Fund (NYSEArca: SHVY).

HVPW is designed around an index called the NYSE Arca U.S. Equity High Volatility Put Write Index. The benchmark tracks the performance of options sold on a basket of 20 stocks chosen from the largest-capitalized equities that have the highest volatility, as determined by NYSE Arca Inc., the filing said. It said each company included in the index will have to have a market cap of at least $5 billion.

Each listed put option included in the index has a 60-day term. The strike price of each put option—the price at which each can be exercised—included in the index must be as close as possible to 85 percent of the closing price of the option’s underlying stock price as of the beginning of each 60-day period.

The new ETF will attempt to track the performance of its underlying index by selling listed 60-day put options in proportion to their weightings in the index. By selling an option, the fund will receive premiums from the buyer of the option, which will increase the fund’s return if the option is not exercised and expires worthless.

However, if the option’s underlying stock declines below the strike price, the option will finish “in-the-money,” and the ETF will be required to buy the underlying stock at the strike price, effectively paying the buyer the difference between the strike price and the closing price.

The filing said that over time, HVPW will seek a correlation of 0.95 or better between its performance and the performance of its underlying index. A measure of 1.00 would represent perfect correlation.

Potential Risks

The proposed fund comes with a number of significant risks. The underlying stocks in the fund’s underlying index are chosen precisely for their volatility, which means that although the leverage of the HVPW options on the underlying stocks increases the potential for returns, the potential for losses also is increased.

For example, although the fund will collect premiums on the options it writes, its losses could outweigh the gains to the fund from the sale of options if one or more of its options is exercised and expires in-the-money, according to the prospectus.

In addition, unlike most exchange-traded funds, HVPW intends to effect redemptions primarily for cash, rather than primarily in-kind redemptions.

As such, investments in Shares may be less tax efficient than investments in exchange-traded funds that rely primarily on in-kind creations and redemptions.

Three exisitng ETFs

Alerian MLP (NYSEArca: AMLP)

ALPS Equal Weight (NYSEArca: EQL)

Cohen & Steers Global Reality Majors (NYSEArca: GRI)

 

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