Ever since the financial crisis, the term financial innovation has become a dirty word. Despite the fact that complex mortgage backed securities almost took down the US economy, there have been other areas of financial innovation that have given retail investors tools that were only available to large institutional investors and the ultra wealthy previously. Many of these take advantage of the scale of financial institutions yet enable the little guy to trade like a hedge fund manager.

In previous posts, I have pointed towards the ability of investors to isolate foreign market exposure. The easiest way to do this is through the iShare ETF’s offered by BlackRock. For example, if you have particular country knowledge or you simply have an outlook on foreign interest rates, you can take unhedged positions in countries as varried as China, Japan, France or Brazil. Although this hasn’t been as lucrative since the financial crisis, when those markets do start to perk up, the demand for their equities as well as their currencies will act as catalysts to each other and provide rocket fuel to returns. Currency gains were an important part of the 2003-2007 rally in both European and Emerging Market shares. This is one reason why the Wall Street consensus sees value shares as well as foreign shares outperforming in the near term.

Another tool that has become popular as well as controversial are leveraged ETF’s. Leveraged ETF’s were first launched by ProShares in 2006 which provided 2 times the daily return of indexes which included the S&P 500, the Nasdaq 100 and the Dow. This was done through derivatives such as index futures, equity swaps and index options. Just as you can go long in these contracts you can also go short, so at the same time the leveraged long ETF’s were offered, short ETF’s were also offered. For the first time retail investors could short an entire index as long as they had the starting capital to do so. They could even use these products to leverage the short positions just as they do the longs. This was in contrast to having to borrow from a broker and short the ETF or a stock directly in the past.

Difficulty in Timing the Market

As many investors know however, there is a lot of difficulty in timing the market. You don’t know when exactly a small dip will turn into a free fall or if it will roar back. This is why experts advise that you stay invested at all times and is the reason that long term investors tend to extract a risk premium to their returns.

Timing is the reason why trying to use a leveraged ETF to hedge a long position can be problematic. Since markets fall fast and then rise slowly, a phenomenon which is likened to taking the elevator down and the stairs up, a better hedge would rally relatively predictably when there is chaos and edge back down as things tend to normalize. A short ETF would be difficult to do in this manner because it would essentially involve someone trying to time the bottom of a stock market drawdown, the technical term for when there is a big sustained drop. This is going to be near impossible on an emotional level when the financial media is freaking out and people worry that things could simply fall further.

In addition, the derivatives used to mimic the daily return of these indexes have what is called “drift” over time due to the cost of having to reset swaps and futures positions and roll them over. This involves a cost as well as a recalibration of the position to a new basis which is why the twice daily return of the S&P 500 for many of these ETF’s doesn’t correspond to the twice annual return of the index. It can sway either way, to the negative or positive side of drifting but it remains likely that drift will occur.

This then presents a risk to trying to hedge your portfolio over a longer period of time like a few months or weeks with a short index ETF. It will still tend to offer a hedge but due to the need to call a bottom and the drift from an index return, it can potentially even add risk to the exact portfolio you were trying to hedge.

Alternative Methods of Hedging

Yet there are products and ETF’s that may be better able to take advantage of the chaos of markets when equities are falling and you don’t want to sell a long position because you see it’s value long term.

One way to protect yourself is through put options. Longer dated put options can protect your downside when there is market turbulence. You can look at them as an insurance contract against your position falling. You pay and if nothing happens, you lose your premium payment. However if something does happen, the contract will pay out.

Yet these too can prove expensive over time. Risk averse investors could end up with huge opportunity costs on the money they spend on hedging the downside. If those downsides don’t appear, they could have used that money spent on put options to go even longer in a bull market and take advantage of the upside. Additionally, when the options expire worthless, 100% of the capital is lost.

It’s for these reasons that hedging through VIX futures may be one of your best bets to hedge the downside when there is market turmoil.

How the VIX Can Offer a Hedge for Stocks

The CBOE Volatility Index or VIX is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of an index such as the S&P 500. It is derived from the prices of index options with near term expiration dates. It generates a 30 day forward projection of volatility. As many readers may know, volatility increases option values so higher volatility means that the index moves up in value when the market has large price swings. This usually happens when the market is trending downwards. The chart below from Investopedia shows how the VIX tends to spike when the market falls.

It’s worth noting also that the VIX movement is much more than that observed in the index. For example, when S&P 500 declined around 15% between August 1, 2008, and October 1, 2008, the corresponding rise in VIX was nearly 260%.

If you were hoping someone made an ETF to be able to take advantage of this, you would be in luck. I tracked down 3 liquid ETF’s that capture an increase in volatility and offer a potentially lucrative hedge to a volatile equity market, increasing in value just when things get difficult for investors.

• ProShares VIX Mid-Term Futures ETF (VIXM) – This ETF is structured as a commodity pool, a type of private investment that combines investor contributions to trade commodities futures and options. The fund tracks the S&P 500 VIX Mid-Term Futures Index, which measures the returns of a portfolio of monthly VIX futures contracts having a weighted average of five months to expiration. The expense ratio is 0.87% and the assets under management are $93 million. The 3 month average daily volume is around 83,000 shares.
• iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) – This is structured not as an ETF but rather an exchange traded note or ETN which means it carries the credit risk of the financial institution that issued it as well. VXX tracks the S&P 500 VIX Short-Term Futures Index Total Return, offering exposure to a daily rolling long position in the first and second month VIX futures contracts. Like VIXM above, VXX does not represent a spot investment in the VIX, but instead is linked to an index comprised of VIX futures. As a result, it may perform very differently from the fear gauge as well. The expense ratio is 0.89% but the 3 month average daily volume is much greater at 55 million daily and assets under management of $1.6 billion.
• ProShares VIX Short-Term Futures ETF (VIXY) – Like VIXM above, VIXY is also structured as a commodity pool. The fund tracks the S&P 500 VIX Short-Term Futures Index, which follows the movements of a combination of VIX futures and is designed to track changes in the expectation for VIX over a specific short-term time window. The expense ratio is 0.87% and the assets under management are $428 million. The 3 month average daily volume was 8 million shares.

How Did They Perform During the Last Drop?

From trough to peak, VIXM rallied about 125% during a 1 month period from February 10 to March 16, 2020. However, since the ETF tracks mid term futures, the gauge remained elevated since then.

On the other hand, since VXX and VIXY track short term futures, these ETF’s shot up as the market fell. Each rallying from trough to peak at about 350% but followed then by a sharp fall.

So the medium term VIX ETF would seem to offer a more stable hedge for when an investor can start to get a better feel for the market direction, while the short term ETF’s offer huge upside if there’s volatility but followed by a rapid descent as things return to a more orderly creep up.

So in conclusion, with bonds offering little return and becoming more and more correlated with equity returns, a short term exposure to the VIX in times of stress could partially protect many investors who are exposed and long only.

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