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Can volatility ETFs protect in a crash?

Fears are mounting among investors of a stock market correction. But is investing a part of your portfolio in volatility really a viable hedging strategy?
August 13, 2014

The VIX index, which demonstrates the market's expectation of 30-day volatility, has been rather flat since 2011, so private and professional investors alike think that a rockier period may be due.

The Investors Chronicle recently reported that because of this, professional investors are taking profits from stock market investments, and increasing the cash element of their clients's portfolios as a "safe house" instead. They say opportunities in the equity and bond markets in recent months have become so scarce that it is now safer to keep a significant proportion of assets in cash, and a number of wealth managers and multi-asset funds managers have swapped 10 per cent of their clients' investments for cash or cash alternatives such as money-market funds.

But cash rates are at historically poor levels, and even worse when held in a stocks and shares individual savings account (Isa) or a self-invested personal pension (Sipp). A number of cash alternative funds have done so badly that they actually managed to lose money over the past year.

If you believe the markets are heading for a rocky patch, another way to hedge your portfolio against a correction is to invest in an exchange traded fund (ETF) that tracks volatility. These ETFs are designed to grow in periods where the market is under stress, when implied volatility (the volatility that options traders expect) is high. In most cases, they are intended as a hedge, an investment which will rise when the market is falling, though their value can also rise when the market is making large gains.

However, far from a safe house, these ETFs are highly risky and better suited to professional investors. Many of them are based on complicated investment strategies which track futures. If the cost of the new futures is more than what the ETF gets for selling its existing futures contracts, it makes a loss, known as contango, which is not good for investors in the ETF.

Barclays iPath exchange traded notes are some of the first generation volatility ETFs in the UK, and among the best known. They invest in futures contracts on the VIX index which is costly, and the longer they are held the more their total returns diverge from index. For example, since the iPath S&P 500 VIX Short-Term Futures ETN (VXIS) was launched, the VIX index is down 21.9 per cent, but the iPath ETN is down 97.8 per cent.

But Source ETF has developed a range of ETFs that use different combinations of cash and derivatives to try to protect its funds from this gradual loss of value. It has recently launched a macro hedge ETF, which aims to offer a cost effective, long-term exposure to volatility that reacts to changing market conditions - Source JP Morgan Macro Hedge Dual Vega Target 4 per cent TR UCITS ETF( MHVT). If an investor had bought this ETF in January 2009 and held it to June 2014 they would have enjoyed a gain of 915 per cent, according to simulated historical performance calculations in Source's marketing material.

The ETF's strategy takes a two-pronged approach: in times of market stress, it aims to capture spikes in volatility, while in normal market conditions it aims to generate a positive return.

Source says it can achieve this by combiningg long and short investment strategies. Going long allows investors to hedge their equity portfolio as the futures generally go up when markets go down. And going short (betting on the price of an asset falling) on futures over time tends to generate a small, steady amount of money. But the downside to this is that when stock markets sell off you lose a lot of money. This strategy targets a 4 per cent vega, which means it also scales investors' futures position up or down depending on circumstances.

Peter Sleep, senior investment manager at Seven Investment Management, says: "The hypothetical past performance of this ETF is too good to be true. The period over which the historical performance is drawn is selective. In effect, this product has been constructed to do well with 20:20 hindsight. It has been fitted to the period 2009 to 2014.

The drawback with this strategy is that if you get the timing wrong, you could lose a lot. Provided that all our future crises are slow burn and not sudden shocks, I am sure you will do well in this strategy. You may not do so well if there are any sudden shocks like Lehman."

And Adam Laird, head of passive investing at Hargreaves Lansdown, says: "I'm wary of these funds. I think that they should only be considered by investors with experience in this area. Traditionally, these have been short-term investments, and timing has been crucial. Most individuals won't have the ability to get the timing right. If you need to protect your portfolio from volatility, it's better to hold a portion in cash."