Wednesday, December 5, 2012

PowerShares to List Actively Managed Downside Hedged S&P ETF

By Tim Dulaney, PhD

Late last week, Invesco PowerShares filed a form N-1A registration statement with the SEC to list an exchange traded fund (ETF) with exposure to the S&P 500 with downside exposure actively hedged through VIX futures contracts.  The PowerShares S&P 500 Downside Hedged Portfolio (PHDG) seeks to "achieve positive total returns in rising or falling markets that are not directly correlated to broad equity or fixed income market returns" and has annual operating expenses of about 39 basis points.

The fund will follow a "quantitative, rules-based" strategy and have as its benchmark the S&P 500 Dynamic VEQTOR Index (PDF).  The fund will dynamically allocate exposure to S&P 500 equities and VIX futures contracts that "reflect exposure to the S&P 500 VIX Short Term Futures Index" (PDF).   Under normal circumstances, the fund allocates "between 2.5% and 40%" of fund assets in VIX futures.  In a July 2010 preliminary registration statement, Direxion layed out the plans for a very similar ETF but that ETF was never launched.

Barclays offers a similar product -- Barclays S&P 500 Dynamic VEQTOR ETN (VQT) -- in the form of an ETN that tracks the S&P 500 Dynamic VEQTOR Total Return Index.   This ETN currently has assets of around $350 million, has an annual fee of about 95 basis points according to the fact sheet (PDF) and has realized a price return of over 25% since its August 30, 2010 inception.

The idea behind this strategy is related to the observation that when equity volatility is high, equity markets tend to underperform.  As a result, the exposure to short-term VIX futures contracts (the best proxy we have for exposure to volatility) should partially hedge the downside risk of the equity exposure when volatility spikes. 

However, since the fund will invest in short-term futures contracts, the fund will have to "roll" the contracts each month and as a result will be exposed to negative roll-yield when the VIX futures market is in contango -- contracts expiring later are generally more expensive than those expiring sooner.  In addition, the registration statement notes that
[u]nlike most ETFs, the Fund currently effects creations and redemptions partially for cash and partially in-kind, rather than primarily in-kind, because of the nature of the Fund's investments. As such, investments in the Fund's Shares may be less tax efficient than investments in Shares of conventional ETFs that utilize an entirely in-kind redemption process.
To put it all together, PHDG is trying to strike a balance between the purported hedging benefits of volatility exposure and the roll yield that comes from holding that position, which is the fundamental issue with volatility exchange-traded products generally.  Our research suggests that hedging with short-term volatility futures may not be effective (PDF) using simple rolling strategies, so the future of this product space may be to develop more and more complicated dynamic strategies.  We'll continue to watch this ETF and other related exchange traded products as they gather assets and post returns.

No comments:

Post a Comment

Please keep comments appropriate. Malicious comments or solicitations will be removed.