By Gaurav Sinha, Associate Director, Asset Allocation and Modern Alpha at WisdomTree.

Gaurav Sinha, Associate Director, Asset Allocation and Modern Alpha at WisdomTree.

Besides the yield curve that our fixed income team likes to talk about, there is another curve that inverted recently, and that warrants attention from asset allocators in Q4 2019.

Typically, the Chicago Board of Options Exchange (Cboe) Volatility Index (VIX) is an upward sloping curve – VIX contracts further out trade higher than the nearer contracts. This means there is more uncertainty as you go further out in the future.

However, in August, this trend reversed, and VIX one-month contracts traded higher than VIX three- and six-months contracts. We can blame this higher near-term uncertainty on trade tensions, slowing growth, and Federal Reserve (Fed) policy. In any case, it means risk is back in vogue. For asset allocators, this implies hedging volatility is more critical now than it was earlier this year.

Source: WisdomTree.

Historically, here’s what an inverted volatility curve has meant:

• Higher volatility in the near term.
• More negative equity swings.
• Higher income opportunity via selling volatility contracts.

Source: WisdomTree.

How Can WisdomTree Help?

As volatility comes back into the conversation, the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW US), which tracks the Cboe S&P 500 PutWrite Index could be a great instrument for providing long exposure with the ability to mitigate downside risk during volatile markets.

A few PUTW highlights:

• During upward trending markets in 2017, PUTW still delivered returns above 10%. The S&P 500 Index was up approximately 22%.
• Similarly, in 2009, the PUT Index rose 31.5%, outperforming the S&P 500, which returned 26.5%
• PUTW has a beta of approximately 0.6, thus reducing volatility.

In periods when the VIX curve inverted, the PUT Index has beaten the S&P 500 by a large margin:

Source: WisdomTree.

Conclusion

PUTW can be a great hedge in this environment. If there is a trade resolution or market rally, PUTW’s strong positive correlation to equities could potentially provide positive returns. If markets fall, it can help provide cushioning and income, especially in a more volatile environment.

Investors should be cautious of buying either pure short or pure long volatility strategies. The former can potentially wipe out total exposure, while the later can act as a drag on total returns due.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)