Carl Noble   |   August 2, 2012

We continue to position portfolios at neutral levels of risk, believing that the substantial downside risks (Europe, the looming fiscal cliff, an economic slowdown, etc.) are balanced by the growing possibility that global central banks may soon inject more stimulus that could propel risk markets higher again — similar to what’s happened the past two years (see our June Market Review for more details on our outlook).

However, the downside risks are such that we continue to carry positions that should help to hedge, or defend, in the event that those negative scenarios come to pass. For example, approximately 15% of our Dynamic Moderate Growth portfolio is currently allocated to various hedges, including Long-Term Treasury bonds, the U.S. dollar index, gold, and oil. Each has its own unique characteristics that may help if equities come under pressure, depending on the security. While we still view those as attractive hedges, we’re always on the lookout for other ideas, too, and at the end of last week, we purchased a new kind of hedge that should serve as a nice complement to the others – the iPath S&P Dynamic Volatility ETN (symbol XVZ).

XVZ is an exchange-trade note that is designed to allow different amounts of exposure to volatility depending on conditions in the futures markets. Volatility in this case refers to the CBOE Volatility Index (VIX), which attempts to measure expected near term volatility for the S&P 500 Index based on options prices. The VIX has historically been highly negatively correlated (moves in the opposite direction) to the stock market, and is commonly used as a ‘fear/greed’ indicator because it tends to spike during periods of market stress, and tends to drift lower during market rallies (this relationship is shown in the chart). Because of those qualities, volatility has become an increasingly popular investment option for investors seeking some level of downside protection for their stock positions.

The ETN that we purchased follows a rules-based methodology that allows it to vary its exposure from being fully exposed to volatility, to being minimally exposed, depending on the shape of the futures curve for volatility contracts (which changes depending on market conditions). The reason that it was designed to be able to vary its exposure is that volatility can be very expensive to simply ‘own’ over a longer period of time due to the nuances of how contracts are bought and sold in the futures markets. So the idea here is to be able to own something that should defend well in difficult markets, but shouldn’t be a horrible drag in positive markets.

This is a rather sophisticated product that we’ve been looking into for several weeks. We expect it to help soften the blow in the event that the market rolls over and volatility increases, which is possible if (insert your current favorite market risk) actually happens. And if volatility stays low, we believe this instrument is much better to hold than other similar products due to its dynamic properties.