It’s an intriguing notion. Bear market bottoms have historically been marked by volatility spiking to certain levels, so when such readings arise, it may be advantageous to shift more aggressively into equities. Vice versa, when volatility descends to historically low levels for long stretches, the investor should be prepared to reduce exposure to equities.

In this post, I’d like to look at using a “VIX ETN” as another way to hedge against market downturns. It’s an approach Yamada is studying and may adopt.

In February, two exchange-traded notes (ETNs) began trading: iPath S&P 500 VIX Mid-Term Futures (VXZ) and iPath S&P 500 VIX Short-Term Futures (VXX). Both reflect movements in futures contracts trading on the CBOE Volatility Index (VIX), the “fear gauge that measures the level of anxiety in the market.

The basic idea would be to purchase an ETN as insurance when volatility declines to its lower boundary and is “cheap” and/or begins to climb and rises past certain thresholds. They would be sold when volatility crests and/or starts edging down again.

However, volatility investments are still a new concept for most investors and they need to be studied carefully before use. Indeed, several caveats should be mentioned right off the bat.

First, ETNs are the debt instruments of the issuers (usually large banks) and are thus subject to credit risk. They also have different tax treatment. For more details, see this Investopedia.com article.

Second, like commodity ETFs (as explained in a section to this Globe and Mail article), they may not track spot prices all that well: if VIX futures are in contango (contracts further from expiration have higher prices), the “negative roll yield” means that ETNs could decline even if actual volatility remains the same or rises slightly. But there should be some offset from the interest earned on Treasury bills put up as collateral for the futures.

Regarding the performance of VXX, Roger Nusbaum notes: “The short-term ETN fund has tracked closer to the underlying index (VIX) than the medium-term fund has … the VIX generally has a negative 0.66 correlation to the S&P 500, and the Short Term Futures ETN captures 40% to 50% of that effect.”

Both ETNs levy annual fees just under 0.9%. The short-term futures ETN is the more popular of the two, with over $200 million (U.S.) in assets. Trading volume is averaging more than 500,000 daily.

Actually, the tracking doesn’t look too bad thus far according to the Yahoo chart below. Over the past six months, as the market rebounded, the VIX has declined just over 40% while the VXX is down nearly the same.

If the market has historically yielded an average 8% to 10% annually over the long run, then borrowing to double exposure to the market would return over 16% to 20% a year (before expenses) to the long-term investor.

Buying stocks on margin has its problems, of course. Interest rates on debt cut into the returns. And if the investor doesn’t have the cash or nerve to respond to margin calls during market corrections, the approach loses its advantages.

Leveraged exchange-traded funds (ETFs) offer fresh hope for the leveraged indexing approach. They don’t have margin calls. And costs appear to be low – annual fees are in the vicinity of 1%. An example is the ProFunds Ultra S&P 500 ETF (SSO), which delivers twice the daily performance of the S&P 500 Index.

Alas, there are substantial caveats on using leveraged ETFs for long-term investing. Tristan Yates of investment advisory Index Roll explains them well. They are also summarized in this article.

A solution may be to rebalance one’s position in a leveraged ETF. As it goes down an investor buys more and as it goes up, they sell off units. This can offset the change in market exposure due to the daily rebalancing that the fund has to do to maintain its leverage factor of two.

The Horizon BetaPro family of leveraged funds offers a “rebalancing tool” on their website for such a purpose. I asked Tristan Yates what he thought of it.

“Using the term ‘rebalancing’ might make you think that you’re maintaining your original index exposure over time,’ he said, “but that’s not the case.” It only directs investors to make up half the loss of exposure. If the index falls $1, investors take losses of $2 and index exposure falls $2. “If you wanted to keep the exposure constant, you would have to contribute $2….” But the tool just asks for $1.

It provides protection but just half way against the constant leverage trap. Investors could conceivably then rebalance with double the amount the tool tells them. That way the leveraged ETF should be more assured of returning close to twice the index (before fees) over long periods.

A challenge, though, is the sums involved when extreme situations arise. If the index falls 40% to 50% over time, the amount to be added to the ETF according to the tool (without doubling up) “could cumulatively equal or perhaps even exceed the original investment,” Mr. Yates warns.

So, annual average returns of 16% to 20% (before fees) may be possible but getting there may require more emotional and financial discipline than most investors have. And after fees, including the fund’s transaction fees etc, the net return might come in closer to 12% to 16% a year. That’s better than unleveraged ETFs but is it worth the hassle? Thoughts anyone …?

The positive insider-trading signals include: i) large dollar amount purchased (up to a point), ii) several purchases made over previous three months, iii) several insiders buying in same period, iv) insider buying after a positive earnings announcement, v) insiders buying a value stock vs. a growth stock, vi) buying by senior executives in a small company, and vii) buying when a company has a stock buyback program.

There is little on the site to confirm it actually belongs to him but rcarrick is from Canada and he (or she) joined Covestor.com in late October, a few days before Rob Carrick’s column on Covestor.com and other social-investing websites appeared in the Globe. Perhaps while visiting Covestor.com as part of his research, Rob decided to link his brokerage account? Portfolio highlights:

- nine holdings with a tilt toward income investments
- all down, with Nortel Networks the most
- loss since inception is -13% (would be smaller if dividend income included)
- purchases in last 2 months were Fortis, RioCan Trust, and Yellow Pages Trust.

Rcarrick’s portfolio:
TransCanada Corp.
Manulife Financial Corp.
Mainstreet Equity Corp.
Fortis Inc.
RioCan Real Estate Investment Trust
Cameco Corp.
Yellow Pages Income Fund
Peyto Energy Trust
Nortel Networks

There are plenty of other model portfolios around. Here are more Canadian examples. Here are more U.S. examples. Canadian Capitalist has the Sleepy Mini Portfolio and even yours truly has the One-Minute Portfolio.

One thing I find interesting is how top active investors recommend passive indexing for most investors. You can’t find better endorsements than that.

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” Warren Buffett, CEO of Berkshire Hathaway Inc. (1996 shareholder letter to investors)

“Most investors would be better off in an index fund.” Peter Lynch, former star manager of Magellan Fund (Barron’s interview, April 2, 1990)

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.” Benjamin Graham, father of value investing (1976 Financial Analysts Journal interview).

“Most of my investments are in equity index funds.” William F. Sharpe, 1990 Nobel Laureate in Economics (1998 Business Week interview)