First Trust Files For A Different Kind Of Hedged S&P 500 ETF

by on October 20, 2011

First Trust, the Chicagoland-based ETF issuer responsible for the AlphaDEX lineup of products as well as a variety of first-to-market sector products, appears to be dipping its toes into another corner of the ETF world with its latest filing. In the SEC release, the company laid out plans for a CBOE VIX Tail Hedge Index Fund which looks to face the stiff competition from the many products in the large cap blend Category. However, the fund does look to employ a unique methodology which could give it a leg up on its more entrenched competitors, possibly giving investors an interesting new way to play the space. Although expense ratio and ticker symbol information were not released, we have highlighted some of the key points from the filing below: 

The proposed fund seeks to invest in the S&P 500 Index, with dividends reinvested, as well as a component to hedge against volatile markets. This is done by buying an amount of one-month, 30-delta VIX Call Options which is determined by the current level of forward volatility in the marketplace. According to the filing, the allocation to the VIX Call Options will be done in the following way:

  • When VIX Futures are below 15, no VIX calls are purchased
  • When VIX futures are between 15 and 30, 1% of the portfolio goes into VIX calls
  • When VIX futures are between 30 and 50, 0.5% of the portfolio goes into VIX calls
  • When VIX futures are above 50, no VIX calls are purchased

This method has the effect of limiting the number of calls purchased during extremely low periods of volatility and it also has the effect of taking profits when extreme volatility levels are in the market place. The idea behind this structure is that historically, deep market declines have been correlated with a medium level of expected future volatility; huge declines rarely happen in periods of extremely high or extremely low volatility [see all the volatility ETPs here].

The technique also looks to provide investors with a nice ‘tail risk’ hedge– hence the name of the fund– should markets collapse suddenly and investors are forced to deal with massive equity losses in a short period of time.  In fact, according to information from the CBOE, this index methodology would have greatly outperformed a pure bet on the S&P 500 by a wide margin during the tumultuous period of late 2008 when markets were crashing [read Volatility ETPs: Where Are The Critics Now?].

According to a white paper (PDF) on the index on CBOE’s site, “In October 2008, VXTH (the symbol for the index in question) earned 1.48% while the S&P 500 lost 21.36%. This is the month when the tail hedge went to work. The trade-off was a cut in the rate of return in most non-crisis months. The average rate of the S&P 500 in these months was 0.7% and that of VXTH was 0.59%.” In other words, investors subscribing to this fund’s tactics will be paying a premium for a potentially very lucrative insurance policy should markets go south in a hurry. However, if markets remain stable or just slowly trend downwards, the calls seem unlikely to pay off and could result in underperformance. Given this, investors need to weigh the value of this insurance policy with the higher fees and the potential for lower returns in non-crisis periods in order to decide if this tactic is for them [Volatility ETFs: The Real Safe Haven?].  


Very few products look to use this type of dynamic hedging as most of the funds in the Large Cap Blend Equities ETFdb Category implement ‘plain vanilla’ tactics that focus on replications of an index.  While some recent additions to the space look to segment the large cap space more thoroughly, a few look to provide dynamic approaches as well. Two of the most well-known are likely to be TRND and SPGH, both of which combine investments in gold with broad equity allocations, although, it should be noted, they do this in very different ways [Compare SPGH to TRND here]. Beyond these products, BARL, which allocates half of its exposure to crude oil and half to the S&P 500, also offers some degree of diversification above the regular index as well [When ETNs Are Better Than ETFs]. 

Although all of these are likely to pose some challenge to a possible fund from First Trust in the space, the main competition looks to be from Barclays and that company’s ETN+ S&P VEQTOR ETN (VQT). This fund tracks the S&P 500 Dynamic VEQTOR Total Return Index which seeks to provide investors with broad equity market exposure with an implied volatility hedge by dynamically allocating its notional investments among three components: equity, volatility and cash. The fund cycles between the three depending on levels of volatility with more of the fund going towards volatility during high periods of uncertainty and more towards equities when volatility is at low levels [see more on VQT's Fact Sheet]. The product has a little over $90 million in assets and trades about 30,000 shares a day so while it has a decent sized lead, it is by no means insurmountable, suggesting that if this proposed fund from First Trust can get by the regulatory hurdles, it could see decent inflows from investors seeking more protection in the space. 

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Disclosure: No positions at time of writing, photo is courtesy of Payton Chung.