Direxion, the firm that recently rolled out a pair of Insider Sentiment ETFs, got the ball rolling on the product development front in 2012 with the launch of three volatility response ETFs this week. The new ETFs offer dynamic exposure to U.S. and Latin American equity markets, shifting allocations between stocks and cash based on market volatility:
- Direxion S&P 500 RC Volatility Response Shares (VSPY): Linked to the S&P 500 Dynamic Rebalancing Risk Control Index, this ETF will consist of exposure to T-Bills and large cap U.S. stocks through the S&P 500.
- Direxion S&P 1500 RC Volatility Response Shares (VSPR): S&P Composite 1500 Dynamic Rebalancing Risk Control Index, this ETF includes exposure to small, mid, and large cap stocks.
- Direxion S&P Latin America 40 RC Volatility Response Shares (VLAT): S&P Latin America 40 Dynamic Rebalancing Risk Control Index, this ETF consists of exposure to an index that includes 40 of the largest Latin American equities.
The idea behind these ETFs is relatively simple; during periods of relatively high overall market volatility, investors may wish to shift their portfolio towards low risk securities, such as Treasury Bills. When market volatility subsides, higher allocations to risky assets such as stocks may be advantageous [for analysis of all new ETFs, sign up for the free ETFdb newsletter].
For example, the widely-followed CBOE Market Volatility Index, also known as the VIX or the “fear index,” gives insights into the expectations for short-term equity market volatility. The correlation between the VIX and U.S. stocks is negative; when market volatility is elevated, it generally means that investors are anxious. That anxiety often leads to big swings in value, and has a history of causing dismal returns to stocks. When the VIX spiked in the fall of 2008, equity markets tumbled:
There are more recent examples of similar performances. During August and September of last year, the VIX jumped by about 70%. The S&P 500 lost nearly 12% during that stretch. Since peaking in early October the VIX has steadily declined, and was recently down about 50% over that period. In the same timeframe, the S&P gained close to 17%. (It should be noted that the new Direxion ETFs do not rely directly on the VIX to determine their portfolio allocations; these examples are meant to show the inverse relationship between stock market volatility and stock market performance).
Based on the volatility of the underlying index, the allocation of the new Direxion ETFs will shift. At the “target volatility” level, the ETFs will be invested 100% in the equity benchmark (following chart is from direxionshares.com):
Under The Hood
VSPY, VSPR, and VLAT will shift exposure between the related stock indexes and Treasury Bills based on measures of market volatility, meaning that the underlying portfolios will generally be a blend of stocks and low-risk bonds. The new ETFs will be nimble–meaning that they can make adjustments to changing market conditions frequently and quickly, even on a daily basis if the methodology dictates. Adjustments to the split between equities and T-Bills are made on a monthly basis, at minimum.
According to the prospectus the stock component of the ETFs is expected to range from 28% to 150%, meaning that these products could utilize leverage to amplify exposure in certain environments. The cash component would vary between 0% and 28% of the portfolio.
Unlike daily leveraged ETFs that require regular monitoring, these new ETFs can be seen as buy-and-hold investments. VSPY, for example, should be viewed as a potential alternative to ETFs linked to the S&P 500 Index such as SPY and IVV. For investors looking to limit the downside losses during bear markets, the “volatility response” strategy might be rather appealing.
“These new Funds are an intelligent way for equity investors to mitigate risk,” said Ed Egilinsky, Managing Director, Alternative Investments at Direxion. “Periods of higher than average market volatility tend to coincide, with potentially adverse equity markets, while periods of below average market volatility tend to represent a more stable environment and a greater likelihood of favorable equity market conditions. By tracking indices that use volatility to dictate overall equity exposure, these Funds serve as a means for investors to gain exposure to equities, while seeking to help protect their portfolios.”
Each of the three new ETFs will charge an expense ratio of 0.45%. Direxion has also filed details for similar “volatility response” ETFs that would offer exposure to small cap U.S. stocks and the NASDAQ.
VQT’s Impressive Returns
Though the volatility response ETFs from Direxion are the first of their kind to begin trading, they will have at least some similarities to a Barclays ETN that has grown increasingly popular in recent months. The Barclays ETN+ S&P VEQTOR ETN (VQT) shifts exposure between stocks, volatility, and cash depending on observable market prices. That strategy served VQT quite well in 2011, as it shifted its allocation to volatility futures as the VIX began to climb. VQT returned about 16.2% in 2011, dwarfing the returns generated by the S&P 500 SPDR (SPY was up less than 2% on the year; compare SPY and VQT with the free head-to-head ETF tool).
The new Direxion products will split exposure between T-Bills and equities; volatility futures are not included.
Last year, more than 300 new ETPs began trading; the three Direxion ETFs that launched Wednesday represent the first additions of 2012.
Disclosure: No positions at time of writing.