Hedging "cliff" volatility might not get you too far

CHICAGO Fri Jan 4, 2013 11:57am EST

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CHICAGO (Reuters) - Once again, "fiscal cliff" mayhem has given investors a furtive look into the unsettling world of market volatility, which will not end with Tuesday's deal. We will likely see more Tilt-A-Whirl politics in the coming two months as Congress deals with the debt ceiling and budget cuts.

Volatility has long been the enemy of the mainstream investor. It is easy enough to measure and hedge, but short-term gauges and volatility products such as exchange-traded notes can get you into trouble. They do not work effectively for buy-and-hold investors and have to be timed precisely for traders.

The skittish mass psychology of 2011 set the stage nicely for exchange-traded products that track or blunt volatility. After a rough summer of debt-ceiling and euro zone gyrations, the S&P 500 barely eked out a gain.

Despite the S&P 500 index's rebound of some 13 percent in 2012, investors yanked more than $150 billion from stock funds during the year. This anxiety propelled sales of more than a half-dozen low-volatility stock and index funds.

The most direct way of addressing volatility is to invest in an index that tracks it. The VIX index from the Chicago Board Options Exchange is one of the most popular, and several exchange-traded vehicles are linked to it. The index tracks "implied volatility" and near-term expectations through S&P 500 index option prices. Generally, it is an inverse gauge to the S&P. When the big-stock index is down, the VIX is up, so it can act as a hedge against major stock sell-offs.

But market volatility does not always track political turmoil. I have been watching the VIX for the past year and it has been a huge disappointment. One of the largest ETFs investing in the VIX is the iPath S&P 500 Short-term Futures exchange-traded note. While it should have ignited like a skyrocket leading up to the "fiscal cliff" deadline on January 1, it was down a heart-stopping 80 percent for the year (through January 2). An exchange-traded note is a publicly traded security issued by a bank.

What makes the VIX so nettlesome is a combination of short-term fears and its linkage to futures contracts - derivatives based on what investors think securities prices will be worth by a certain date.

As measured by the VIX, 2012 on the whole was not a particularly volatile year, at least compared with 2011 or 2008. Yet jangled nerves over the fiscal cliff impasse pushed the VIX past 20 on December 28, the first time it cleared that level since July. A related ETF - the VelocityShares Daily 2X VIX Short-Term exchange-traded note (TVIX) - saw its highest-ever volume on that date, when more than 5 million shares traded, according to ETFTrends.com.

For most investors, though, it is incredibly difficult to predict, much less profit from, short-term volatility. The majority of the time it is an expensive loser's game. The average expense ratio for a VIX-linked vehicle is about 1 percent, compared with less than 0.10 percent annually for an index fund holding all of the S&P 500. Then there are commissions to buy and sell and the inevitable cost of timing errors.

While I like the fact that during the most volatile market periods the VIX soars, it does not happen all the time. If you had invested in the VIX from roughly August 2008 through April 2009, you would have avoided the heart of the housing meltdown decline of the S&P 500. Yet after that trough you would have missed the rebound of big stocks. The iPath would have lost more than 60 percent over the past three years while the S&P was up nearly 12 percent.

Ironically, in trying to hedge against volatility, you take on dramatically more risk over time. The standard deviation, a common measure of price variation, is 73 percent for the iPath over the past three years. That is huge, and can be avoided by simply buying and holding more bonds or lower-volatility stock funds.

LESS-VOLATILE ROUTE

If you are a long-term investor and wisely avoid trying to time short-term market squalls, you are better off in lower-volatility stock funds. Although they do not isolate you from stock market or global/governmental risk, they tend to hold up better over time because they invest in dividend-paying stocks.

Funds like the Vanguard Dividend Appreciation ETF invest in an index of companies that raise dividends over time, as does the PowerShares Dividend Achievers ETF. Both have a three-year standard deviation under 13, compared with 15 for the S&P 500 and more than five times less than the iPath. The PFM fund returned around 11 percent in 2012; the Vanguard ETF nearly 12 percent.

If you are not the kind of investor who wants to buy and hold, yet want to avoid making wrong tactical decisions, you would want balanced funds to make the move between stocks and bonds. The relatively new Direxion S&P 500 DRRC Index Volatility Response Shares ETF tracks volatility signals and automatically shifts your money from stocks to U.S. Treasury Bills when risk levels rise. It rebalances a minimum of once a month. The concept is to reduce downside risk through a dynamic formula.

Ultimately, though, the success of any volatility strategy is how well it times the peaks and valleys of investor behavior, which nobody seems to do very well. You would probably be better-served by taking a look at your risk "budget" - how much you can afford to lose - and adjust your portfolio annually. Even during periods of peak volatility, following the market daily, weekly or monthly is just too much of a carnival ride. If you can't stomach it, stay away and avoid a lot of motion sickness.

(The author is a Reuters columnist and the opinions expressed are his own. For more from John Wasik see link.reuters.com/syk97s)

(Follow us @ReutersMoney or here; editing by Beth Pinsker and Matthew Lewis)

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