Condor Options

First Trust Portfolios L.P. recently announced the launch of the First Trust CBOE S&P 500 VIX Tail Hedge Fund, a fund designed to replicate the performance of the CBOE VIX Tail Hedge Index.

The strategy is very simple. It holds stocks replicating the S&P 500 and, at the monthly VIX expiration, purchases a quantity of front-month VIX calls corresponding to the level of the VIX Index. With VIX<15 or >50, no calls are bought. With VIX>15 and <30, 1% of the portfolio is allocated to VIX calls, and with VIX>30 and <50, 0.50% of the portfolio is allocated to VIX calls.

I don’t want to focus on strategy details here, but I will note that VIX call options are some of the most expensive products in the world: as Reed Hogan explained in his excellent feature for Expiring Monthly, the volatility risk premium in VIX options is even greater than in SPX options, which in turn is greater than in individual stock options. When we researched the VXH strategy, the size of the VIX option premium was one reason we elected to hedge with VIX futures instead.

But strategy issues aside, there are two other reasons to avoid products like VIXH. The expense ratio of the fund is listed as 0.60%. At all times, 99% of the portfolio will be invested in the S&P 500, with occasional periods of 99.5% and 100% SPX allocations during extremely volatile and extremely quiet markets. Let’s grant for the sake of argument that investors should be willing to pay 0.60% for someone to buy some VIX calls for them every month. They should pay that fee on the portion of the portfolio being actively managed. First Trust Advisors is not making any changes or taking any other action with the remaining 99% of the portfolio to justify that 0.60% fee. In effect, they are asking you to pay 0.60% for the S&P 500 when you could just as easily have it for 0.09% or 0.05%:

Table from ETFdb

The same criticism applies to the Barclays VEQTOR product (VQT), which charges 0.95%, although the VQT methodology would be much harder for individual investors to replicate and VQT is at least managed daily. First Trust’s product is rolled monthly.

Including vanilla SPX exposure in a tail risk hedging ETF is a design flaw. What about all those investors who want exposure to assets other than S&P 500 stocks – that is, the vast majority of investors? These products are of little use to them. That’s the first problem, and it would be an important problem even if expense ratios were very low. But they aren’t, and that’s the second reason investors should avoid these products: there is no reason you should pay these sorts of fees for a portfolio 99% of which is just the plain vanilla S&P 500.

Full disclosure: we offer a tail risk hedging strategy (the VIX Portfolio Hedging (VXH) Strategy) by subscription and in individually managed accounts. I’m obviously biased, but I think it’s clear that the problems with these ETFs are exactly the sort of problems that we solve via the managed account route. VIX positions are allocated based on the size of the account being hedged, which means that the fees charged are only charged on the capital used for hedging – not on the capital held elsewhere in other assets that have nothing to do with us. First Trust, Barclays, and other providers want you to pay through the nose for exposure to AAPL, XOM, and other mega-cap stocks, and we see no reason why you should.