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.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  3. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  4. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  5. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  6. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  7. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  8. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  9. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  10. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>

You May Also Like

Trading Center