Today I’m going to discuss three prepacked investment solutions that seek positive exposure to the equity market with different volatility reduction approaches:
S&P 500 Low Volatility Index: uses stock selection and alternative weighting to minimize portfolio volatility without the use of derivatives or active hedge. PowerShares has issued an ETF (ticker SPLV) that tracks this index.
S&P 500 Dynamic VEQTOR Index: uses a market timing mechanism that dynamically allocates between the 500 and the one-month VIX futures. It continuously monitors the implied volatility and realized volatility of the 500 index to adjust its allocation. Barclay’s has issued an ETN+ (ticker VQT) that tracks this index.
CBOE VIX Tail Hedge Index: uses one-month 30-delta VIX calls to hedge its equity exposure. First Trust will issue an ETF to track this index.
Strictly speaking, the Low Volatility Index has no hedge by design. Its low volatility is achieved by overweighting defensive stocks. When the market falls, the index falls less, but still falls.
The VIX Tail Hedge index uses VIX options as a hedge to its equity exposure. This is a more expensive hedge than using VIX futures. Also, this index does not have any dynamic allocation mechanism that is driven by market signals.
The VEQTOR index uses the most aggressive risk reduction approach among the three. When the market is down, it allocates up to 40% to volatility and expects the gain from the volatility component will more than compensate the loss from the equity component. When the market is up, it reduces its allocation in volatility to as little as 2.5% in order to reduce the hedging cost. It also has a stop-loss function that goes full cash if the index is down by more than 2% over any five-day period.
The performance history shows that VEQTOR outperforms the other two indices in general and tails in returns during a continuously rising market. It has the lowest volatility among the three.