First Trust Advisors, a US-based investment manager, has announced the launch of the First Trust CBOE S&P 500 VIX Tail Hedge ETF (VIXH), an S&P 500-tracking exchange-traded fund (ETF) with an inbuilt insurance mechanism to help protect against extreme market swings.

Robert Carey, CFA, Chief Market Strategist of First Trust.

The NYSE-listed fund employs a tail-hedging strategy which utilises call options on the CBOE Volatility Index (VIX) in an attempt to offset some of the potential losses associated with extreme unexpected events – so-called “black swans”.

“The lesson of the 2008 global financial crisis is that a single severe market shock can devastate entire portfolios and wipe out many years of market gains,” said Robert Carey, CFA, Chief Market Strategist of First Trust.

“Given the surge in interest in tail risk and tail risk hedging in the wake of that crisis, we believe this is an ideal time to launch a fund offering long-term investors a convenient way to attempt to hedge against the risk of similar extreme market events.”

The First Trust CBOE S&P 500 VIX Tail Hedge ETF tracks the CBOE VIX Tail Hedge Index, a benchmark created by Chicago Board Options Exchange (CBOE). This index tracks the performance of each equity security in the S&P 500 Index (with dividends reinvested) and allocates a variable percentage to a long position in a call option on the CBOE Volatility Index (VIX), a measure of implied volatility in the S&P 500.

The index is reconstituted and rebalanced every month. At the time of the index rebalancing, the amount allocated to the call option varies between 0% and 1%, with the balance of the index being invested in an S&P 500 stock portfolio.

During periods of extreme volatility, the out-of-money call options on the VIX index may generate large positive returns that hopefully offset losses in the equity portfolio.

In order to reduce hedging costs, the index varies the weight of the VIX calls at each monthly rebalance. The weight of the VIX calls is dependent upon expected levels of forward volatility as measured by the VIX futures curve.

At low levels of expected volatility (<15%) or extremely high levels of expected volatility (>=50%), no call options are purchased and their respective weight is 0%. At levels greater than or equal to 15%, but less than 30%, 1% of the portfolio is allocated to call options. At levels greater than or equal to 30%, but less than 50%, 0.5% of the portfolio is allocated to call options.

Volatility has been a major theme for investors over the past few years. And with ongoing concerns surrounding the Eurozone debt crisis, uncertainty over the US ‘fiscal cliff’’ and continued unrest in the Middle East, volatility is likely to be factor investors will continue to have to contend with.

To help investors navigate through these turbulent times, ETF providers have rolled out an array of products, each with a slightly different take on volatility. The majority of assets within this space have gravitated towards ETFs which seek to minimise volatility. Funds in this category include, for example, the hugely popular ($2.35 billion in assets) PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) in the US and the Ossiam ETF US Minimum Variance (USMV) in the UK.

This latest fund from First Trust, however, is perhaps most similar to the TSX-listed Horizons Universa US Black Swan ETF (HUS.U), which launched in Canada earlier this year. [See Horizons rolls out ETFs with built-in “Black Swan” protection].