With several market sectors correcting by more than 10% this year, volatility has become an issue that investors are being forced to face for the first time in a while. A number of ETFs exist that offer downside mitigation and risk hedges, including one from Rob Emrich’s Acruence Capital, which offers the Acruence Active Hedge U.S. Equity ETF (ticker: XVOL). He and his strategic partner, John Elder, the founder of data science firm, Elder Research, join the ETF Think Tank to discuss risk strategies and the proper way to execute them.
How does data science work exactly? Elder explains that it involves learning from the past something that can be useful for the future. His group uses domain knowledge to figure out what the important factors are and find other periods in time that are like it. There are several challenges in developing models properly. This biggest issue is what if the future is not like the past. The pandemic offers a good example of that. Researchers also need to identify what works without disregarding what didn’t work. You can learn, but you can also overlearn.
XVOL begins with a core position in the S&P 500 and uses a proprietary, volatility-based algorithm to determine the number of VIX options contracts to purchase, as well as the strike price(s) and expiration date(s) of the options. Emrich partnered with Elder to develop this algorithm, who studied the VIX to find opportunities, but also determine whether or not the program could fail and the algorithm could be broken.
Elder found that with the VIX, the curve is unusual and not very smooth. If your inputs are similar, you hope that your outputs are similar, but in order to be successful, it really just needs to be in the right direction. He notes that models can be fooled if you simulate a lot of scenarios and just pick the best and you need to run a lot of alternate histories to see if your strategy would get fooled by those histories. Emrich adds that there’s not as much signal in surface volatility as you might think.
While most ETFs are based on the premise of a quality back test, Elder says he never trusts a back test until he has run one himself. He only deals with something that can be replicated 100%. He’s seen clients push ahead with models that couldn’t be adequately replicated and watched them crash because the client was manipulating the older data. Individuals need to be honest in developing models and always use 100% clean data.
Other key takeaways:
- Emrich says that he’s seen a lot of tail risk strategies that are currently being implemented but doesn’t think a lot of them are terribly successful. A lot of marketers develop stuff that looks cool, but it’s never been tested in a real environment. A lot of the products that exist today are just built in a marketing machine and that’s one of the marketplace’s biggest weaknesses.
- With XVOL, Emrich says that his fund uses a fixed dollar hedge, not a fixed notional hedge. This helps him better understand how much capital could bleed over the next year. As he looks at the curve and decides how much he wants to pay for VIX exposure, it can sometimes affect how much exposure he can layer on. Tails are becoming more expensive, and more people are using the VIX to hedge.
- Emrich says some current hedge vehicles are good, but they’re not S&P 500 replacements. If you’re going to replace your core position with a 15% hedge, that’s going to degrade your portfolio principal significantly over, say, 5 years. He wanted to develop a product that could outperform the S&P 500. If one of these tail events occurs once every 10 years, we can pick up a lot of return that benefits the fund over the long-term.
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The S&P 500® Index is composed of 500 selected common stocks most of which are listed on the New York Stock Exchange. It is not an investment product available for purchase. The Chicago Board Options Exchange (“CBOE”) Volatility Index (The “VIX” Index) estimates the expected level of volatility in the U.S. stock market, as reflected by the S&P 500, forward-looking over 30 days. It is not possible to invest directly in an Index.
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Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV) and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns. Investments involve risk including the possible loss of principal. There is no guarantee the investment objective will be successful. Options can be volatile and have a large impact on the performance of the Fund. There is a risk of loss of all or part of the cash paid (premium) for purchasing options and the value of the option may be lost if not exercised at or prior to expiration. One of the primary drivers of the value of a VIX Option is movement in the spot value of the VIX Index, which is a measure of implied volatility of S&P 500 options. Therefore, changing market expectations of future volatility will lead to changes in the market value of VIX Options. Because implied volatilities often rise during periods of market stress, the VIX Index is often negatively correlated to equity markets.
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