New 'Tail Hedge' ETF Hunts Black Swans

| About: First Trust (VIXH)
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ETFs designed to provide jittery investors with a hedge to protect against market sell-offs have been popular, and the business is rolling out more products to capitalize on the trend.

First Trust recently launched a new "Black Swan" styled ETF that pairs a tail risk hedge with equities, which will help limit an investor's downside risk.

Call it a sign of the times. Investors are very cautious and many are putting a premium on safety and insurance in the market.

For example, iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX) and VelocityShares Daily 2X VIX Short Term ETN (NASDAQ:TVIX) have been big sellers this year. Volatility-linked exchange traded products are designed to track VIX futures contracts, and some investors use them to protect against market downdrafts.

According to a press release, the First Trust CBOE S&P 500 VIX Tail Hedge Fund (NYSEARCA:VIXH) began trading on August 30. The fund tracks 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." The index holdings are reconstituted and rebalanced monthly.

The tail hedging strategy protects a portfolio from extreme market oscillations as a result of unpredictable, random and unexpected events, or so-called Black Swan events. The term was coined in a 2007 book by Nassim Nicholas Taleb published right before the financial crisis hit.

VIXH has a 0.60% expense ratio and includes 500 holdings - the ETF is currently tracking S&P 500 stocks. It should be noted that the fund is rebalanced monthly to allocate toward VIX options if needed and it also reinvests dividends, which will add on transaction costs and may weigh on performance.

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.

The VIX is currently at around 18.

Allocations to the VIX will help diminish hedging costs by limiting the number of VIX calls purchased during periods of low expected volatility. On the flip side, VIXH is expected to profit during periods of high volatility.

Top holdings include Apple (NASDAQ:AAPL) 5.0%, Exxon Mobil (NYSE:XOM) 3.2%, Microsoft (NASDAQ:MSFT) 1.8%, International Business Machines (NYSE:IBM) 1.8% and Chevron (NYSE:CVX) 1.8%.

Sector allocations include: consumer discretionary 10.9%, consumer staples 11.1%, energy 11.2%, financials 14.3%, health care 11.7%, industrials 10.1%, information technology 20.2%, materials 3.3%, telecom services 3.2% and utilities 3.5%.

"The lesson of the 2008 global financial crisis is that a single severe market shock can devastate entire portfolios and wipe out many years of market gains," Robert Carey, CFA, Chief Market Strategist of First Trust, said in the press release. "Given the surge in interest in tail risk and tail risk hedging in the wake of that crisis, we believe this is an ideal time to launch a Fund offering long-term investors a convenient way to attempt to hedge against the risk of similar extreme market events."

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.