Institutional investors worried about the U.S. fiscal cliff and the European debt crisis think a so-called tail risk event is a very real possibility over the next year.
Although the stock market is a stone's throw from all-time highs, many investors don't seem to believe in the rally and 2012 and are looking for ways to protect their portfolios. The desire to hedge has triggered a "bull market in fear" as investors continue to buy volatility-linked ETFs at a rapid pace this year.
A new ETF is designed to address the tail risk of "black swan" events that would trigger deep sell-offs.
The First Trust CBOE S&P 500 VIX Tail Hedge Fund (VIXH) tries to reflect the performance of the CBOE VIX Tail Hedge Index, which follows the S&P 500 Index and allocates a percentage to a long position in a call option on the CBOE Volatility Index, or "VIX."
If VIX futures are less than or equal to 15, no VIX calls are purchased. If the VIX is above 15 or less than or equal to 30, 1% of the portfolio will be in VIX calls. If the VIX is above 30 and less than or equal to 50, 0.50% of the portfolio will be in VIX calls. If VIX futures are above 50, no VIX calls are purchased.
"This design attempts to reduce hedging costs by limiting the number of calls purchased during periods of expected low volatility and has the effect of taking VIX option profits when extreme volatility levels are reached," according to a First Trust research note.
"Tail risk means the risk of a sudden and steep drop in market valuations, a down move of 20% or more," according to a CBOE VIX Tail Hedge Index white paper. "What makes VIX call options such a good remedy for tail risk is that these options may generate astronomically high returns in turbulent periods."
Basically, the strategy hedges against unpredictable, random and unexpected events. The term black swan was coined in a 2007 book by Nassim Nicholas Taleb published right before the financial crisis hit.
In a recent study, State Street Global Advisors, along with the Economist Intelligence Unit, found that 71% of institutional investors think it is "highly likely" or "likely" that a significant tail risk event will take place over the next year. Respondents cited the crisis in the Eurozone, a potential global or European recession and a slowdown in China among their top concerns.
Additionally, 64% of the institutional investors pointed to liquidity of the underlying instruments as the major challenge in allocation to a tail risk protection strategy.
Max Chen contributed to this article.