When the Markets Are a Game of Risk, Keep This Fund in Your Quiver

It's often said that the best way to make money is to not lose money. That has been tough so far this year, without taking on risks in the form of extremely concentrated positions in energy and commodities. We've looked at exchange-traded funds like long-short ETFs that provide broad-market exposure, while offering downside protection. We've also looked at funds that use options to boost investor returns in down markets. Here, however, we'll look at a fund that focuses on equity returns and the volatility of those returns to determine what the issuer believes is an appropriately hedged portfolio. A Litmus Test for PHDG The Invesco S&P 500 Downside Hedged ETF was launched in June 2012 and tracks the S&P 500 Dynamic Veqtor Index. The fund has an expense ratio of 39-basis points, but with the inclusion of 2-basis points of acquired fund fees and an offsetting 1-basis point waiver, it nets to an even 40-basis points. This means a shareholder with $1,000 invested over a calendar year would pay $4 in fees over the period. For actively managed funds the best place to read about the portfolio manager's process is the fund prospectus, but as this fund is passive, the best source to learn about the strategy is the index methodology. As mentioned earlier, this strategy sets its position weights daily by focusing on the returns of equities in the form of the S&P 500 Index and the volatility of those equities in the form of the CBOE Volatility Index (VIX). The constituents of the index are the constituents of the S&P 500 index, the constituents of the S&P 500 VIX Short-Term Futures Index (the front- and second-month VIX futures), and cash. Observing volatility is the primary approach to determining the overall mix between equities, VIX futures, and cash. The methodology outlines steps to create an implied volatility trend indicator that compares the trailing 5-day and 20-day averages of the VIX. If the 5-day rolling average is greater than the 20-day for 10 consecutive days, then a volatility Uptrend has been established and if there have been 10 days of the opposite, then a downtrend is in place. Anything in between signals no trend. These trends are then matched up with the realized volatility of SPX and using the below matrix assigns the appropriate weight to VIX futures with the balance allocated to equities. The methodology also outlines that should the index decrease more than 2% over the previous five business days then the index shifts to a 100% allocation to cash. Wrapping It Up You can see the interplay between the 5-day, 20-day averages and realized volatility play out in the below year-to-date return chart to Tuesday. PHDG participates in the slide at the beginning of the year until the point that the allocation is reconfigured to become more defensive. As the S&P fund recovers and begins to rally, PHDG reallocates and begins to participate until the allocation mechanism gets triggered once again. Over longer periods of time, this fund does underperform SPY, but when it matters, it manages volatility and provides some cushion, while still providing broad market exposure. I like this approach, if only because unlike a lot of other trend-following funds that take a more binary approach with 50- or 200-day moving averages to signal risk on / risk off, this fund (index, really) has a number of triggers that allow the fund to manage risk in a more nuanced way. If you think that the markets are going to continue to exhibit the same kind of volatility and continue to grind lower, then look to PHDG.

When the Markets Are a Game of Risk, Keep This Fund in Your Quiver

This ETF manages risk in a nuanced way.

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