First Trust announced this week the launch of a new ETF that will combine exposure to one of the world's most widely-followed stock market indexes with VIX call options. The new First Trust CBOE S&P 500 VIX Tail Hedge Fund (VIXH) will seek to replicate an index that includes each component of the S&P 500 along with a variable percentage allocated to a long position in a call option on the CBOE Volatility Index (better known as the VIX), a unique combination that should allow it to limit downside loss potential while still offering considerable upside. The underlying index is reconstituted every month .

Mitigating Risk

The idea behind VIXH is relatively straightforward; it provides investors with exposure to a core asset class while also providing downside protection that may limit losses in the event of steep declines in equity markets. Because the VIX tends to spike during sell-offs (it is, after all, also known as the fear index), the call option held by VIXH should see a significant appreciation in value if stocks tumble. That can potentially help to offset losses in the components of the S&P 500.

The downside, of course, is that the call option will often expire worthless when stock market climb or even move sideways. Investors are effectively paying a small premium for an effective form of portfolio insurance. But if it turns out that the protection wan't needed (e.g, a bull market) VIXH will probably lag slightly behind ETFs that simply seek to replicate the S&P 500 .

It doesn't take much allocation to the VIX call option to provide significant protection; VIXH will allocate between 0% and 1% to this asset class depending on market conditions .

"The lesson of the 2008 global financial crisis is that a single severe market shock can devastate entire portfolios and wipe out many years of market gains," said Robert Carey, CFA, Chief Market Strategist of First Trust. "Given the surge in interest in tail risk and tail risk hedging in the wake of that crisis, we believe this is an ideal time to launch a fund offering long-term investors a convenient way to attempt to hedge against the risk of similar extreme market events."

Risk Mitigating ETFs

VIXH is one of several ETFs that allows investors to maintain exposure to large cap U.S. stocks while limiting their downside risk. The PowerShares S&P 500 Low Volatility Portfolio (SPLV) targets the components of the S&P 500 that generally exhibit the lowest volatility. RBS offers a Large Cap Trendpilot ETN (TRND) that oscillates between the stock index and cash depending on market conditions.

Direxion also offers a S&P 500 RC Volatility Response ETF (VSPY) that maintains dynamic weights to the S&P 500 and cash that adjust based on stock market volatility.

The new ETF will charge an annual expense ratio of 0.60%. Plain vanilla exposure to the S&P 500 is available for as little as six basis points annually, while two more S&P 500 ETFs (SPY and IVV) charge just 0.09%.

Disclosure: No positions at time of writing.

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