Last week's sharp drop in equity prices coupled with a quick rebound helped to spike volatility to levels not seen since early March. It's a reminder that even though the S&P 500 is still within a few percent of its all-time high, small-caps and tech stocks are further below their peaks and tensions among traders are high.
While the economic recovery narrative still has many believing that stocks have further upside in front of them, the risks of higher inflation, soaring debt and a potential pullback in Fed market support leave the financial markets susceptible to more sharp, short-term corrections. It may be time to more seriously consider portfolio hedges to protect against current downside risk.
In a world of financial market uncertainties, we know that one thing is generally true - spikes in volatility are almost always associated with declines in risk asset prices.
This is just over the past five years, but we can see that even modest spikes in volatility above around the 20 level are correlated with pullbacks in equities prices. Generally speaking, the larger the VIX spike, the greater the pullback in stock prices.
It makes sense then to believe that owning a long position in an equity index coupled with some type of exposure to the VIX could be a really nice combination for protecting against downside risk.
The Acruence Active Hedge U.S. Equity ETF (XVOL) launched last month and is designed to do just that. According to the fund's website:
Acruence invests nearly all of the XVOL assets in a portfolio replicating the constituents and weights of the S&P 500 Index, while seeking to reduce volatility by purchasing options contracts on the VIX (CBOE Volatility Index). Acruence uses a proprietary, volatility-based algorithm to determine the number of VIX options contracts to purchase, as well as the strike price(s) and expiration date(s) of the options.
The long position in the S&P 500 is pretty straightforward. The VIX contract position is a little more nuanced. The company looks at expectations for volatility over the near-term as well as the time premium for such options, the current level of the VIX and the relative value in options pricing. Acruence expects VIX contract exposure to be roughly 1/12 of an annual allocation of 2% to 5% of XVOL’s assets purchased and contracts purchased generally have expirations of 6 months or less.
The natural comparison for XVOL might be a covered call ETF, such as the Global X S&P 500 Covered Call ETF (XYLD), since they both overlay options contracts on top of an index. Covered call strategies, obviously, have a different objective than something like XVOL, but it's interesting to compare the two from a structural standpoint.
XVOL vs. QYLD
QYLD tracks the CBOE Nasdaq-100 BuyWrite V2 Index, so it's going to be a little more formulaic in its option strategy. Every month, the fund will write a one-month out-of-the-money call option on the index and hold it until the day prior to expiration. It will take the sale proceeds and use that towards writing the next call option and that process repeats itself over time.
XVOL, on the other hand, is actively-managed, so it has more freedom to pivot based on current market conditions. It can add or subtract exposure at any time. It can use current month expiration contracts or target those with expirations as much as 6 months out into the future. It's essentially taking a more data-backed approach to determine appropriate VIX exposure at any given time.
XVOL is only a month old, so there's almost no historical data with which to work. Since it's actively-managed, there's no index to track down for backtesting either.
Here's the one-month chart of XVOL measured against the S&P 500. Since it's very thinly traded, I'm not sure there's much we can learn from the chart.
For the most part, it's tracked the S&P 500 including the brief period where the VIX got into the upper-20s.
All we can really do is judge how XVOL might fit into a portfolio as it (hopefully) grows progressively larger over time. Overall, I think the strategy of combining the S&P 500 with a VIX hedge makes a lot of sense. We know the two are inversely correlated and the fact that the VIX position is actively-managed and adjusted according to market conditions makes it even more attractive.
It's too small to make any fair judgments on it now, but XVOL is definitely worth watching throughout the remainder of 2021 and beyond.