SmartETF

The Volatility Index Family Tree

Unique homework, a capital idea! Thank you for this contribution. Parallel to this is the Family Tree of Risk. The early ETF's mirrored the broad market indices. The next wave was a land grab for sector indices; increasing the risk anywhere from 1.2 to 8.3 times the volatility of the broad markets. Then came the sub-sector ETF’s (example, biotech), inverse funds and leveraged funds; risk for these are in the nose-bleed section. Not until mid-2006 did we see a reversal in risk with the introduction of non-equity based ETF’s such as fixed income, real estate and commodities.

It would be nice to have a volatility index that targets each asset class and sector in each country. We do this using Extreme Value Theory which incorporates fat-tail events (using Stable Distributions) and GARCH to properly weigh the data. Short of this complexity, a basic volatility index would at least demonstrate the general level of volatility.

ETF Investment Risks

An overlooked metric is volatility risk. As the land-grab for ETF shelf space continues so does the increase in volatility. The first ETFs were broad-based market indices, like the S&P 500. The next wave of ETFs was the industry sectors (health care, financials, basic materials, etc.). Because they are less diversified the risk on one industry, in terms of volatility (measured in standard deviation) is 1.3 to 8.6 times the volatility of the S&P 500. Having seized the industry sector space the ETF manufacturers went to the sub-sector frontier to build their niche (such as bio-tech); and henceforth more risk. Not to be out done, competing manufactures launched inverse funds and leveraged funds; again, more risk. Only since June of last year has the risk in new ETF’s subsided with the introduction of fixed income, real estate and some commodity ETF’s. The largest risk in managing a portfolio of ETF’s is in choosing the proper fund universe; then comes the ardent task of fundamental research and asset allocation.