As investors grow more familiar with the exchange-traded product
structure, many have started to utilize these instruments for
tactical exposure and not just as buy-and-hold building blocks in
their portfolios. After equity markets logged a stellar performance
in 2013, volatility has rightfully been a key concern for many
investors looking to navigate this year’s ups and downs on Wall
Street. Andy O’Rourke, Managing Director and Chief Marketing
Officer at Direxion, recently took time to discuss some of the
headwinds that could plague markets in 2014, in addition to
explaining the differences between two seemingly identical
low-volatility strategies.
ETF Database (ETFdb): Broadly speaking, what are some high-level
expectations that you have about volatility levels in 2014 compared
to the environment seen last year?
Andy O’Rourke (AR): We have been in a period of historically low
volatility for quite some time. Outside of a few brief spikes
post-credit crisis, the VIX has been mostly below 20 for the past
few years. This low-volatility environment has coincided with
a strong run in equities. The bull market in equities has entered
its sixth year. The S&P 500 had its largest annual jump in 16
years in 2013 and as of 4/15/2014 the cumulative return of the
index is up 203% from the 3/9/2009 low [see also Low Volatility
ETFdb Portfolio].
We also haven’t experienced a 10% or greater correction in quite
a while. Most investors have become complacent and increasingly
bullish because of this. The market historically has been very
effective at correcting extremes and excesses in both directions.
It does seem likely that at some point in the near future,
volatility will rise and return to historically average levels. If
history tells us anything, that development will likely
coincide with a market correction, as market performance and the
VIX are negatively correlated for the most part. The timing,
duration and size of the increase in volatility are the big
questions.
So far this year we have already seen volatility trend upwards
and spike a bit in response to a few unexpected market-moving
events, such as the turmoil in emerging markets (specifically
China), geopolitical concerns (Russia/Ukraine) and hawkish
commentary from the Fed indicating that interest rates could rise
sooner than previously expected. The VIX ended the year slightly
below 13 and quickly rose above 20 in early February before falling
back a bit, but it’s still up more than 13% for 2014 so far (as of
4/15/2014).
ETFdb: In terms of headwinds, what do you think is arguably one
of the more understated risks that could plague U.S. equity markets
this year?
AO: There are many headwinds facing the
equity markets, but in keeping with the theme here, probably the
most understated risk is the looming increase in volatility. We do
hear a fair amount on a day-to-day basis about the VIX and what the
level of volatility is in the markets in general, but we don’t
often hear too much about the impact higher volatility can have on
the performance of equities over time. We find that many people are
undereducated on this concept [see also Andy's Explanation of How
Leveraged ETFs and Compounding Work].
There are several other headwinds that may impact the markets,
including:
- Geopolitical risks, such as the situation involving Russia and
the Ukraine, which could escalate.
- Interest rates rising faster and sooner than expected.
- Rising inflation.
- Unemployment not decreasing as fast as expected, or even
increasing.
- Slowing economic growth (some economic readings have been below
expectations).
- Slowing earnings growth (there were some high-profile misses in
Q1).
- Slowing economic growth overseas (China).
- Consumer slowdown.
All of these headwinds can create a stormy market environment.
As investors consider all of these factors, and the chance that
many could occur simultaneously, they should be looking for some
investment vehicles that provide downside market protection.
ETFdb: What advice would you give to investors who are looking
to smooth out volatility in their portfolios, but are wary of
giving up exposure to the strong bull market at hand?
AO: We find these days that most investors, particularly those
that have already accumulated some wealth, are primarily focused on
preserving their capital. In a broad sense, this translates to
creating a portfolio that is very well-diversified and provides a
significant amount of downside protection. Everybody loves to
obtain the maximum benefit from the equity markets when they are
rallying, but it is important to create a portfolio that includes
exposure to various asset classes, including alternatives, which
have a low correlation to traditional asset classes [see
also How To Be A Better Bear: Short Selling vs. Inverse
ETFs?].
Direxion has developed an ETF that offers a very interesting way
to gain exposure to broad equities with a built-in methodology that
provides protection against adverse, volatile
markets. The Direxion S&P 500 DRRC Volatility
Response Shares ETF (VSPY) is a rules-based strategy ETF that
provides investors with exposure to the S&P 500, but modifies
this exposure level based on how volatile the markets are at any
point in time.
High volatility is often a precursor to a bear market, and can
certainly deliver significant drawdowns that all investors look to
avoid. VSPY is designed to self-adjust its exposure to the S&P
500 based on the amount of volatility present in the market. When
volatility is low the fund will be fully invested in equities, but
if volatility is higher the exposure to equities will be gradually
scaled back, and the difference will be invested in T-bills.
ETFdb: Can you explain the difference between low-volatility
ETFs, like the PowerShares S&P 500 Low Volatility fund (SPLV),
and Direxion’s Volatility Response Shares ETF (VSPY)?
AO: These strategies are similar in that they are both seeking a
common goal of providing investors with a way to experience the
return potential of equities, but at the same time, limit their
exposure to severe volatility. The methods of achieving this,
however, are different. Many low-volatility funds in the market are
looking to identify particular stocks that are expected to offer
lower volatility, as compared to the rest of the stocks in the
S&P 500. However, this is done by assessing those stocks’
volatility levels over the past 12 months. While this is certainly
the best information available, there is nothing that says their
volatility will not pick up substantially in a very short period of
time. We have seen this time and again. These types of products
also tend to have a bias towards certain low-beta sectors, so
diversification across various equity sectors can sometimes be
impacted.
Direxion’s VSPY looks to achieve the low-volatility goal by
consistently providing proportionate exposure to all stocks in the
S&P 500, but adjusting exposure to the entire benchmark based
on the overall volatility of the benchmark. Historically,
performance has typically strengthened when volatility has been
low, presenting a good opportunity to be fully invested.
Conversely, during periods of high volatility, performance has
weakened, indicating a good time to decrease exposure to the index
and put a portion of the fund’s assets into T-bills.
What’s nice about VSPY’s methodology is that it uses a very
straightforward formula to determine the desired exposure level,
which makes the fund very simple to understand for
investors. The overall goal is to provide returns that are
comparable to that of the S&P 500, but with reduced volatility,
or standard deviation. The fund has done well in this regard since
it was launched in January 2012.
The Bottom Line
Investors can protect their portfolios from the adverse effects
of rising volatility in a number of ways thanks to the
proliferation of ETFs; whether its inverse ETFs, bonds funds, or
low-volatility focused strategies, there is no shortage of
instruments out there that can help smooth out a bumpy ride in
the markets. Direxion’s VSPY warrants a closer look under the hood
from anyone looking to achieve exposure to the ongoing bull run in
equities while at the same time maintaining the ability to
dynamically scale back on risk if warranted.
Follow me on Twitter @SBojinov
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Disclosure: No positions at time of writing.
Click here to read the original article on ETFdb.com.
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