From the April 2012 issue of Research Magazine • Subscribe!

March 26, 2012

Handling Stock Volatility With ETPs

Investment decisions must take into account a perennial and unpredictable constant: stock market volatility. Some years, as in 2011, the fluctuation of stocks is more pronounced. At other times, volatility is almost like a sleeping giant and hardly noticeable.

Day-to-day portfolio management is not just a process of growing capital or producing adequate income, but also controlling volatility to make sure it doesn’t exceed clients’ expectations. For financial advisors, this particular chore means coming up with ways to keep a lid on both risk and volatility.

There are various approaches to volatility management and ETPs offer innovative ways at helping advisors to achieve optimal results.

Trading Volatility

The VIX — short for Volatility Index — is one of the best known barometers of stock market fear. The VIX is a measure of expected future volatility calculated by the Chicago Board Options Exchange (CBOE). It is quoted in percentage points and roughly translates to the expected movement in the S&P 500 over the next 30 days, which is annualized.

ETPs like the iPath Inverse S&P 500 VIX Short-Term Futures ETN (II) (IVOP) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) allow traders to customize the duration of their exposure to volatility.

Other VIX-based ETPs like the VelocityShares Inverse VIX Short-Term ETN (XIV) offer inverse or opposite exposure to stock market volatility, while products like the VelocityShares 2x Short-Term ETN (TVIX) aim for 200 percent daily leveraged exposure.

It’s important for advisors to understand that VIX ETPs do not perfectly track the spot prices for the CBOE Volatility Index because they use futures, which could be in contango. Finally, VIX-based products are offered in either ETF or ETN wrappings from Barclays iPath, Citigroup C-Tracks, Credit Suisse, ProShares, UBS E-TRACS and VelocityShares.

While many investors reject the notion of investing or trading off of volatility, some advisors welcome it as an opportunity, so long as they can control it.

Stock Selection

Screening stocks with lower volatility or beta is one strategy for managing market volatility. The idea is to be invested in the market, but with stocks that have less wild movements compared to the rest of the market.

The Russell 1000 Low Beta ETF (LBTA) is designed to deliver exposure to stocks that have low predicted beta using a screening and ranking methodology. Starting with the lowest beta stock, a target portfolio is created by adding the next lowest beta stocks until the target portfolio has a total capitalization of 35% of the Russell 1000 Index. A portfolio of up to 200 stocks of the Russell 1000 Index are selected to optimally track the returns of the target portfolio while managing turnover and neutralizing exposure to other factors, such as volatility and momentum. LBTA is linked to the Russell-Axioma U.S. Large Cap Low Beta Index and charges 0.20% net annual expenses.

The PowerShares S&P 500 Low Volatility Portfolio (SPLV) is another ETF that applies a similar strategy. SPLV consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. The fund’s annual expense ratio is 0.25%.

Dialing Down (or Up)

Emerging market stocks is a high risk/high reward investment category packed with volatility. During the 2008-09 financial crisis, the volatility in emerging markets was especially large. After sinking more than 52% in 2008, emerging market stocks bounced back with a remarkable 75% gain the following year. The Direxion S&P Latin America 40 Volatility Response Shares (VLAT) attempts to tame the wild ride. The fund reallocates exposure between equities and U.S. Treasury Bills based up recent volatility levels of the S&P Latin America 40 Index. When volatility exceeds the targeted risk level of 18 percent, the exposure to equities is reduced and the exposure to T-bills is increased. Conversely when volatility drops below targeted risk levels, equity exposure is increased proportionately.

VLAT’s strategy of increasing or decreasing market exposure based upon targeted risk levels is different from other volatility strategies like selecting low beta or low volatility stocks. “This is a better risk-adjusted return versus buying static or traditional market index ETFs,” said Edward Egilinsky, Managing Director, Head of Alternatives at Direxion Shares. “It also avoids some of the contango issues that face VIX-based products and can be used as a buy-and-hold investment.”

How does VLAT calculate the optimal level of exposure to stocks? It accomplishes this task by taking the fund’s targeted volatility level of 18% and dividing it by the S&P Latin America 40 index’s volatility level. Exponential volatility of just 10%, for example, would result in an asset mix of zero to T-bills while up to 150% could be allocated to stocks. On the other hand, if volatility soared to 88%, the asset mix would change with T-bills getting 80% exposure and stocks just 20%.

 Portfolio Application

Where do ETFs that aim to reduce stock market volatility fit within an investment portfolio?

“The most common will likely be for investors who are worried about volatility to move some of their conventional ‘core’ asset allocation into these ‘low-volatility’ funds,” said Michael Iachini, CFA, CFP and managing director of ETF Research at Charles Schwab Investment Advisory. “Low-volatility funds are harder to use tactically, since they’re still exposed to the market and will likely fall in value during a downturn. In this sense, they can be used as a bit of a tactical hedge for investors whose outlook on the market is generally negative. Moving to a low-volatility fund can be seen as somewhere between being fully invested in the market and moving assets out of stocks and into bonds or cash.”

Another strategy is to use beta and volatility busting ETPs in more volatile asset classes like emerging markets or small cap stocks. This allows clients to still be invested, but to mute the unwanted gyrations. Ultimately, managing volatility is an achievable milestone and ETPs can help. L

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