Consider aTemporary Portfolio Hedge with a Volatility ETN

Volatility ETNs can serve as tools to protect assets that you already have in your portfolio. For example, 80% of the time over the last year, the iPath S&P 500 VIX Mid-Term ETN (VXZ) moved in the opposite direction of the S&P 500 itself. It follows that an active investor could purchase exchange-traded note protection if he/she is concerned about the magnitude of this seasonal stock rally.

How should you do it? Rather than sell economically sensitive U.S. stock ETFs in your mix – possibly subjecting yourself to short-term capital gains or potentially “throwing off” your allocation — you might purchase VXZ with a weighting of 5%-10%.

The downside of doing so is fairly straightforward. VXZ is likely to drift lower if the market moves sideways; it’s likely to sell off sharply if the S&P 500 experienced a parabolic rise from current levels.

Examining the downside risks, the likelihood of the S&P 500 going on a rampage after a 26% jump off the October lows seems somewhat remote. (Even bull markets tend to take “breathers.”) What’s more, the CBOE S&P 500 Volatility Index (VIX) is testing lows that haven’t held up for very long during the 3-year bull market period.

 

Even if the VIX broke to new lows, and the S&P 500 surged through 1400, iPath S&P 500 VIX Mid-Term ETN (VXZ) would probably be confined to a 10% drawdown from current levels. One can even use a stop-limit loss order to make certain of the outcome.

Now let’s look at the flip side of the coin. Stock assets across the board are technically overbought; Greece could still go awry; Syria and Iran are wild cards; market gains have removed some of the pressure for Europe to act quickly to prevent debt contagion; the U.S. economy is still growing at a pace that is far below trend. (Why else do you think that Bernanke is committed to 0% rates until 2014!)

In a pistachio nut shell, a flare-up is well within the realm of possibility… if not the realm of probability. Even a health-restoring pullback can occur with little-to-no provacation. That’s why a volatility note like iPath S&P 500 VIX Mid-Term ETN (VXZ) may act as a buffer if you’re more actively-inclined.

Over the course of the last year, ”VIX” volatility spiked on three occasions: (1) February tsunami-March “Arab Spring”, (2) August U.S. debt ceiling debate/September Eurozone debt fears and (3) November public referendum disaster by the Greek prime minister. From the low to the highs, VXZ gained 19%, 65% and 26% respectively.

Briefly, then, one might anticipate a 20%+ gain in VXZ during a significant spike in volatility. Moreover, it happened on 3 occasions last year alone, suggesting that the phenomenon is hardly infrequent.

While the small weight in the portfolio will not change your returns dramatically, it may certainly reduce total portfolio losses by 1.5% to 2%. That can be attractive when the world appears to be coming apart at the seams.

Again, iPath S&P 500 VIX Mid-Term ETN (VXZ) is best used as a trading tool… not a buy-n-hold-n-forget-it investment. I would consider VXZ at this particular moment because it is the furthest below its 50-day moving average (14%) at any point during the 3-year stock bull. That’s a seriously ”oversold” ETN in a seriously “overbought” market.