Source has teamed up with one of its shareholders, investment bank JP Morgan, to offer a long-short equity volatility strategy in exchange-traded fund format.
The JP Morgan Macro Hedge US TR Source ETF has been listed on the London Stock Exchange and trades in US dollars, with an annual management fee of 0.25 percent. The ETF aims to provide cost-effective, long-term exposure to volatility, according to Source.
The fund’s underlying strategy involves maintaining a constant long position in futures contracts based on the Chicago Board of Exchange volatility index (VIX), while taking tactical short positions when warranted by the shape of the futures curve. The VIX is a popular measure of the implied volatility of options contracts on the S&P 500 equity index.
The new ETF’s underlying index, the JP Morgan Macro Hedge US TR index, maintains a synthetic long position in VIX futures, rolling continuously throughout each month from the second to the third month contract. If the VIX futures curve is upward sloping, a synthetic short position, rolling continuously from the first to the second month futures contract, will be added. The short exposure can vary dynamically from 0 percent to 100 percent of the index, meaning that the strategy’s notional gross exposure to VIX futures can reach 200 percent.
This combination of long and short exposures “mitigates the usual negative carry associated with traditional outright long volatility instruments”, said Rui Fernandes, head of equity and funds derivatives structuring at JP Morgan.
JP Morgan said that, based on a back-test, its Macro Hedge strategy generated average annual returns of over 50 percent between 2008 and 2011. By contrast, ETFs and indices following a naïve, long-only exposure to volatility futures have suffered heavy losses from the VIX futures market’s usual state of contango.
The new ETF will be subject to significant underlying index fees, however, most of which are generated by the strategy’s heavy turnover.
In addition to a flat index fee of 0.75 percent per annum, investors in the strategy will face an additional rebalancing charge of between 0.2 percent and 0.5 percent on each futures “roll”. The level of this charge will be set by the underlying VIX index, with 0.2 percent applying when the VIX is below 35, 0.5 percent when the VIX exceeds 70, and a sliding scale in between.
Since the index’s synthetic long-only futures position is rolled monthly, this rebalancing charge generates a minimum annual turnover-related cost of between 2.4 percent and 6 percent. Rebalancing costs from short futures positions could be higher, since the index rules specify daily increases or decreases in short exposure by increments of 20% if the VIX benchmark moves below or above the average level of the first and second month futures contracts for three consecutive days, subject to a minimum short exposure of 0% and a maximum of 100%.
