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Consider A Temporary Portfolio Hedge With A Volatility ETN

08 February 2012 at 2:59 pm by Gary Gordon     Bookmark and Share    Follow EtfExpert on Twitter

Volatility ETNs can serve as tools to protect assets that you already have in your portfolio. For example, 80% of the time over the last year, the iPath S&P 500 VIX Mid-Term ETN (VXZ) moved in the opposite direction of the S&P 500 itself. It follows that an active investor could purchase exchange-traded note protection if he/she is concerned about the magnitude of this seasonal stock rally.

How should you do it? Rather than sell¬†economically sensitive U.S. stock ETFs in your mix¬†– possibly subjecting¬†yourself to¬†short-term capital gains or potentially “throwing off” your allocation — you might purchase VXZ with a¬†weighting of 5%-10%.

The downside of doing so is fairly straightforward. VXZ is likely to drift lower if the market moves sideways; it’s¬†likely to sell off sharply if the S&P 500 experienced a parabolic rise from current levels.

Examining the downside risks, the likelihood of the¬†S&P 500 going on a rampage¬†after a 26% jump¬†off the October lows seems somewhat remote. (Even bull markets tend to take “breathers.”) What’s more, the CBOE S&P 500 Volatility Index (VIX) is testing lows that haven’t held up for very long during the¬†3-year bull market period.

VIX 3 Years

Even if the VIX broke to new lows, and the S&P 500 surged through 1400, iPath S&P 500 VIX Mid-Term ETN (VXZ) would probably be confined to a 10% drawdown from current levels. One can even use a stop-limit loss order to make certain of the outcome.

Now let’s look at the flip side of the coin. Stock assets across the board are technically overbought; Greece could still go awry; Syria and Iran are¬†wild cards; market gains have removed some of the pressure for Europe to act quickly to prevent debt contagion; the U.S. economy is still growing at a pace¬†that is far below¬†trend. (Why else¬†do you think that Bernanke is committed to 0% rates until 2014!)

In a pistachio nut shell, a flare-up is well within the realm¬†of possibility… if not the realm of probability. Even a health-restoring pullback can occur with little-to-no provacation. That’s¬†why a volatility note like iPath S&P 500 VIX Mid-Term ETN (VXZ) may¬†act as a buffer if you’re more¬†actively-inclined.

Over the course of the last year,¬†”VIX” volatility spiked on three occasions: (1) February tsunami-March “Arab Spring”, (2) August U.S. debt ceiling debate/September Eurozone debt fears and (3) November public referendum disaster by the Greek prime minister. From the low to the highs, VXZ gained 19%, 65% and 26% respectively.

Briefly, then, one might anticipate a 20%+ gain in VXZ during a significant spike in volatility. Moreover, it happened on 3 occasions last year alone, suggesting that the phenomenon is hardly infrequent.

While the small weight in the portfolio will not change your returns dramatically, it may certainly reduce total portfolio losses by 1.5% to 2%. That can be attractive when the world appears to be coming apart at the seams.

Again, iPath S&P 500 VIX Mid-Term ETN (VXZ) is best used as a trading tool… not a buy-n-hold-n-forget-it investment. I would consider VXZ¬†at this particular moment because it is the furthest below its 50-day moving average (14%) at any point during¬†the 3-year stock bull. That’s a seriously¬†”oversold” ETN in a seriously “overbought” market.

VXZ 50 Day

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Disclosure Statement: ETF Expert¬†is a web log (‚ÄĚblog‚ÄĚ) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships. You may review additional ETF Expert disclosure details here.

 

Across those 3 events/time frames, VXZ From the high to the lows on the VXZ movement,

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