ETF Hedges Extreme Market Behavior

NEW YORK ( TheStreet) -- First Trust recently launched the CBOE S&P 500 Tail Hedge Fund ( VIXH) where the word tail refers to some sort of outlying event that would take the equity market lower. The fund is interesting conceptually but is complicated under the hood.

The nuts and bolts are that the fund will always own the S&P 500 and will usually own call options that expire next month on the CBOE Volatility Index, commonly referred to by its symbol; VIX. The amount of VIX call option exposure will depend on the level of the VIX futures due to expire next month. If next month's VIX futures are 15 or less the fund will own no VIX calls. If VIX futures are between 15 and 30 the fund will allocate 1% of the portfolio into VIX calls. If VIX futures are between 30 and 50 the fund will allocate 0.50% to VIX calls and above 50 no calls will be purchased.

The call options selected will rely on a methodology whereby the calls will be out of the money and target a delta of 0.30 which generically means that the options will capture about 30% of the move in the VIX. This could be desirable if there is some sort of outlying event, as noted above, that causes the equity market to go down a lot in short order. The concept relies on VIX going up when stocks go down. VIX is viewed by many market participants as a measure of sentiment or "fear gauge."

Stocks down/VIX up has been reasonably reliable over the years but there is nothing that says VIX must go up when stocks decline. "Probably" is not the same as "will" and anyone considering the fund may want to keep that in mind.

The above description of the nuts and bolts of the fund is as simple as I could possibly make it but there is no getting around the fact that the fund is complex. Complexity is not necessarily bad but it is not wise for investors to invest in products they do not understand. Most ETFs are baskets of stocks or bonds. The niche targeted might be exotic, like the Market Vectors Indonesia Small Cap ETF ( IDXJ), but baskets of stocks are not complex. Complexity often results in investor disappointment because of a lack of complete understanding of what the fund is actually supposed to do.

There are funds that use futures contracts, swaps and other derivatives to deliver an exposure that is more complex than a basket of stocks. In addition to VIXH there are levered and inverse index funds, products tracking Italian bond futures (no, really,) and other products that require some understanding of the derivative products the fund will use and the market being replicated.

A great example of possible investor disappointment can be seen in comparing the iPath S&P 500 VIX Short Term Futures ETN ( VXX) and the actual VIX index. Since inception in February 2009 VXX is down 97% while the underlying index is only down 66%. This is due in part to VXX tracking near term futures not the actual index and the extent to which replacing expiring futures contracts with replacements is often done at a loss, a market condition known at contango.

The expense ratio for VIXH is 0.60% which isn't necessarily expensive if the strategy protects investors from some sort of large market decline, but if the Federal Reserve Bank's policy of QE-Infinity continues to send markets higher, then VIXH will lag plain vanilla index funds.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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