VelocityShares' New Volatility ETFs

You've heard it here before: hedging equity exposure with volatility derivatives is very tricky.

While the CBOE Volatility Index (VIX) and the S&P 500 are negatively correlated suggesting a possible hedging opportunity, you cannot invest in the VIX itself, you have to invest in derivatives (futures or options) linked to the VIX. The simple fact is that this indirect exposure to the VIX does not behave like the VIX itself, making it in the end a rather poor hedge to equities .

But issuers of exchange traded funds (ETFs) continue to develop ever more complex products that attempt to do just that. Several recent funds use highly sophisticated strategies to mitigate the severe losses that come from derivatives-based volatility exposure; the trick is to remove those effects without losing the negative correlation to equities that could make it valuable as a hedge.

On Monday, VelocityShares introduced the Volatility Hedged Large Cap ETF (SPXH) and the Tail Risk Hedged Large Cap ETF (TRSK). Both ETFs target an 85% allocation to the Vanguard S&P 500 ETF (VOO), iShares CORE S&P 500 ETF (IVV), and SPDR Trust Series 1 (SPY). But each also includes a 15% short position in a customized volatility swap. See this more detailed description of the two ETFs .

Essentially SPXH and TRSK use a 2x leveraged volatility ETF (such as UVXY) and an -1x inverse volatility ETF (such as SVXY) in combination. They do so in different proportions. SPXH targets a net 35% long volatility position (roughly equal amounts 2x leveraged and -1x inverse exposure) and TRSK targets a net neutral position. The 2x leveraged position exhibits the compounding effects we have discussed before, which affects the overall volatility exposure. As VelocityShares describes it:

The returns of VIX futures themselves are combining with the mechanics of daily resetting exposures, to cause the volatility exposure to automatically and continuously adjust to the pattern of VIX futures returns, without relying on trading signals or market timing.

If that seems complicated, that's because it is. Here's how VelocityShares sums up the proposition:

Ultimately, investors need to determine the hedge that best meets their objectives by providing them with a high likelihood of hedging the magnitude of equity declines they are concerned about, and exhibiting a negative carry from VIX futures which is proportional to that hedge.

This morning Vance Harwood posted a great rundown of these funds at Six Figure Investing. He ends with:

I don't know what it is about volatility investing, but it seems to have a special talent in producing products with dizzying complexity. In the case of TRSK and [SPXH] we have two funds based on indexes that are based on funds that are based on other indexes that are based on futures that are occasionally synchronized with another index (CBOE VIX).

Couldn't be simpler.

It is not clear if these or other volatility-hedged equity ETFs will take off. There are concerns that the relatively high expense ratios of these products (0.71%) should only apply to the volatility component, since investors can obtain the equity component more cheaply by buying the underlying ETFs directly. In addition, there is some question as to whether such sophisticated strategies can be adequately explained to retail investors. But what is clear is that issuers are continuing to package ever more complex trading strategies in the ETF form.