The Drag Of Disaster Insurance

| About: First Trust (VIXH)

Eric Falkenstein wrote up a pretty epic takedown of Nassim Taleb in general and his recent book "Antifragile: Things That Gain From Disorder," in particular. It was a fun even if very dense read (Falkenstein's post).

Included in the post was a mention of the Universa hedge fund that Taleb is associated with and the strategy which from 30,000 feet is to always be positioned for the next financial apocalypse. Since financial apocalypses don't come along very often the fund endures a series of small losses repeatedly until hitting a monstrous home run when the next apocalypse comes. Hopefully for fund holders the monstrous home run more than offsets all the small losses along the way.

Presumably Universa investors realize this.

This gets to the point of this post which is about understanding the positives of your investment strategy and the drawbacks to it. A good example of understanding the drawbacks is the First Trust CBOE S&P 500 VIX Tail Hedge Fund (NYSEARCA:VIXH). It will generally track the S&P 500 with the objective of not going down a lot when the market goes down a lot because the VIX options it owns should go up when the market goes down a lot.

Similar to financial apocalypses, the market does not go down a lot very often which makes VIX call options unnecessary most of the time. Of course the fund incurs the expense of regularly spending money on VIX calls (every month in this case) that will be unnecessary most of the time, creating about a 1% drag on the fund every month. The 1% can be more or less in any given month but that 1% give or take is a drag on returns. Very generically, it is possible that in a given year the S&P 500 could be up 12% in such a way that VIX never spikes, so the calls persist as a monthly 1% drag causing VIXH to be flat, that is lagging the benchmark by 12% for the year.

You can click here for the CBOE micro site for the index underlying VIXH and there you will find a link to the monthly roll spreadsheet which details the history of what the actual monthly drag for the VIX calls has been.

VIXH is a relatively new fund so it remains to be seen whether it will deliver on the objective of sparing fund holders from the full brunt of a large decline. Owning the fund will require patience along the way and need to be held through the entire cycle to have a shot of paying off.

Obviously I think investing for a result over the course of the entire cycle is valid because that is what our firm does.

The picture is from our first snow storm which was over the weekend. The building is the workshop at the house we recently moved into.