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VelocityShares, a US-based developer of exchange-traded products, has launched the VelocityShares Equal Risk Weighted Large Cap ETF (ERW), an innovative new fund providing an alternative to traditional low volatility and market cap-weighted equity ETFs.
The NYSE Arca-listed fund is linked to the VelocityShares Equal Risk Weighted Large Cap Index, a proprietary index which applies an equal risk contribution concept to a portfolio of US large-cap stocks.
The index is designed to reflect the performance of a portfolio holding a weighted exposure to stocks comprising the S&P 500 Index. The target weighting of each stock is determined using a proprietary risk-weighting methodology that measures a stock’s risk exposure and then weights the positions such that each stock is expected to contribute the same level of risk to the index.
The index comprises all of the stocks in the S&P 500, excluding stocks for which there is insufficient publicly available data to apply the risk-weighting methodology. As of April 4, 2013, the Index included 497 stocks from the S&P 500.
The risk associated with each constituent stock is based on a combination of historic market price movements/co-movements and implied market price volatility and each stock’s sensitivity to market price variation. Historic volatility is based on actual market price changes over a specified period of time, while implied volatility uses option data to infer a perceived level of expected price variation.
A proprietary optimisation model then seeks to weight each stock according to each of the volatility factors separately, such that the expected risk contribution of a constituent stock in the index is equal to the risk contribution of each other constituent stock in the index. The “risk contribution” of a constituent stock is defined as the sensitivity of the volatility of all of the index constituents collectively to a change in the risk weighting of an individual constituent. The resulting weights from each optimisation are then averaged to determine the weight for each constituent.
The maximum weight of each individual constituent stock is capped at 10% of the index. In the event the model allocates a percentage weight to a stock in excess of 10%, the excess is reallocated among the remaining uncapped constituent stocks in proportion to their uncapped percentage weights, subject to the individual percentage weight cap of 10%.
Nick Cherney, Chief Investment Officer and Co-founder of VelocityShares, said: “Investors are interested in low volatility equity portfolios, and equal risk weighting represents an important step forward as a means of intelligently allocating to low volatility stocks. ERW is a further example of our commitment to delivering sophisticated investment instruments to the exchange traded market.”
In the US, the fund, which comes with an expense ratio of 0.65%, will likely compete against the conventional equal-weighted Guggenheim S&P 500 Equal Weight ETF (RSP) and the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV). In Europe, the iShares S&P 500 Minimum Volatility UCITS ETF (SPMV), which provides exposure to a subset of securities within the S&P 500 with the lowest absolute volatility of returns, is probably the closest equivalent to the new VelocityShares fund. That said, the equal risk contribution concept is not new to Europe, with both Lyxor and UBS offering such products, albeit not yet on the US market.