This Fund Thrives on Volatility

09/05/2011 8:30 am EST

Focus: ETFS

It’s a good time take lessons from hurricane season and apply them to your investing strategy, writes Chloe Lutts of Dick Davis Investment Digest.

Last Friday, I went to the grocery store around noon to buy lunch and ingredients for dinner. It was an utter madhouse: shopping carts and stacks of food blocked the aisles, and people were everywhere.

It wasn’t until I got home that I realized why: the hurricane heading toward North Carolina was now expected to slam straight into New York the next day. Perhaps I should have bought more food.

I actually did decide to go back to the grocery store for more supplies a little later, and it was even crazier. There were no shopping baskets to be had, and the checkout lines were beginning to wind down the aisles. The canned soup shelf was becoming noticeably bare.

It’s now well after the storm, and everything turned out more or less fine. There’s still a fairly large tree branch on the sidewalk, but the view from my window is otherwise normal—largely because the storm was not as fierce as expected by the time it hit New York, and to a lesser extent because of our over-preparation, the damage was minimal.

Hopefully people won’t take this as an excuse to under-prepare for our next extreme weather event.

Hurricanes are also famous for the "eerie calm" inside the eye of the storm. On one episode of The Simpsons, a hurricane passes over Springfield, and Homer ventures outside when the eye arrives, thinking the storm is over. A few moments later, he’s almost blown away and his family has to drag him back into the basement.

Choppy markets almost always have their own "eye of the storm," a period when it seems like it might be okay to get back in the market.

Unlike a hurricane, which only has one eye, weak markets can do this fake-out multiple times before they really recover. So don’t be like Homer and rush outside at the first sign of calm—be patient and wait until you’re sure the storm is really over. Wait it out.

I know a lot of these rules are no fun: sit on your hands, wait it out, stay calm. Isn’t there anything you can do to take advantage of the storm? One entrepreneurial New Yorker picked flashlights on Saturday; he set himself up outside a hardware store with a box of them for sale.

Investors have a way to benefit from stormy weather as well. The iPath S&P 500 VIX Short-Term Futures ETN (VXX) outperforms when market volatility is high.

Here’s what Benjamin Shepherd, editor of Global ETF Profits, wrote:

"The Chicago Board Options Exchange Volatility Index, better known as the VIX, tracks the S&P 500’s volatility. This index, which is also called the Fear Index, outperforms when the S&P 500 runs into trouble. When the S&P 500 crashes, the VIX turns in equally large gains.

"This exchange-traded note (ETN) tracks the performance of a basket of short-term VIX futures with an average maturity of one month. As a result, it sports a negative correlation to the S&P 500 and performs well when the S&P 500 declines. By the same token, when markets are flat, the ETN’s performance also remains flat.

"The fund’s 0.89% expense ratio is fairly high, but the fund features little tax exposure, and investors only pay capital gains when they sell the fund. This makes the ETN a cost-effective hedge. Buy S&P 500 VIX Short-Term Futures ETN at current prices."

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