In 2013, the market for alternative investment exchange-traded products seems to revolve  around one word. That word is “hedge.” Judging by their proportion of regulatory filings and launches last quarter, product sponsors are keen on risk-controlled equity and bond plays.  

No surprise there, really. After all, we’re just emerging from one of the most volatile periods in market history. Investors -- and their advisors -- are still a little dizzy after being buffeted by the frets of an impending “fiscal cliff,” a meltdown of the eurozone, further ballooning of the federal deficit and fears of potential asset bubbles.

Overall, the prospects for 2013 are mixed at best. Stocks, while not the raging bargains they were during the recent recession, may still be attractively priced, but their dynamics have changed. The recent equity rebound has largely been market driven. Value plays, starting in early 2009 as corporate profits widened, are now becoming sparse. Currently, the market’s reacting more to political influences such as Fed policy and the deficit debate, causing some pundits to forecast an even riskier environment ahead. With such prospects, they say, a little hedging and bond buying seems prudent. Exchange-traded product manufacturers are happy to oblige.

Hedged Equity

Funds and notes geared to dampen market volatility have proliferated in the wake of the 2008-2009 crash. Some have enjoyed extraordinary success attracting assets. Witness, for example, the Invesco PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which has pulled in more than $3 billion since its May 2011 debut. SPLV is essentially a passive hedge. The fund mirrors a 100-stock portfolio, carved from the S&P 500 Index, representing issues with the lowest 12-month trailing volatility.

Invesco now offers investors a more sophisticated approach to managing volatility with its December 2012 launch of the PowerShares S&P 500 Downside Hedged Portfolio (NYSEArca: PHDG). Like SPLV, the new PowerShares fund invests in U.S. stocks but hedges downside risk through futures contracts linked to that well-known “fear gauge,” the CBOE Volatility Index (VIX).

The VIX is a 30-day forward estimate of equity risk derived from the volatility assumptions embedded in S&P 500 option prices. Generally, the index moves counter to the S&P 500, zigging when the blue chip benchmark zags. Ergo its appeal as a hedge against equity market crashes.

PHDG dynamically parcels out its assets to S&P 500 components, VIX futures and cash by tracking the S&P 500 Dynamic VEQTOR Index. As such, directly competes with the Barclays S&P VEQTOR ETN (NYSEArca: VQT), an exchange-traded note based on the same benchmark.

A different approach to volatility management is taken in VelocityShares’ recent filings for two new portfolios that use exchange-traded funds rather than VIX futures. We profiled the VelocityShares Tail Risk Hedged Large Cap ETF in our January issue (online at http://bit.ly/12TlgZM), which tilts long positions in S&P 500 ETFs against VIX-related portfolios simulating a long volatility straddle. The straddle is designed to maintain a modest long volatility bias, ostensibly offering more insulation from downside, rather than upside, moves in the S&P 500.

A sibling portfolio, the VelocityShares Volatility Hedged Large Cap ETF, is constructed with the same underlying funds, but its volatility straddle has a neutral, rather than a long, bias. Nominally, this fund should offer the S&P 500 holdings the same degree of cover from outsized upside or downside moves.

There’s no guarantee, however, that the volatility straddle will work as the product designers originally anticipated. The contango effect mirrored in long VIX-related exchange-traded products, amplified by inherent compounding, contributed to products racking up some of the category’s worst performance records in 2012. On the plus side, inverse VIX products used in the straddle scored equally, if not more impressive, gains last year.

Hedged Debt

Fear isn’t contained to the equity market. Concerns about rising interest rates pushed fund sponsors to file for three hedged bond ETFs in the last quarter -- two passive and one active.

Yield-hungry investors, who flocked to the junk bond market in the wake of the 2008 market crash, are now becoming spooked. Sell-offs in the high-yield sector indicate a growing concern about potential interest rate hikes, prompting fund sponsors to get products to market that can provide hedged exposure to junk bonds.

Most recently, ProShares filed for an ETF that hedges long positions in high-yield debt with shorts in Treasury paper. The ProShares High Yield-Interest Rate Hedged ETF will track a yet-to-be-named index representing a duration-balanced portfolio aimed at capturing junk bond yields while mitigating potential losses in a rising interest rate environment.

By holding interest rate risk in check, the fund should provide investors purer exposure to credit risk. “Should,” of course, doesn’t necessarily mean “will.” If credit spreads collapse, realized yields could shrink.  

The design of the ProShares fund is identical in concept to that of an earlier-proposed Van Eck Global portfolio. Paperwork for the Market Vectors High Yield/Treasury Bond ETF was filed in November, stating it would track a proprietary index built on the long junk/short Treasury concept.

First Trust, another fund provider, has filed for a junk bond fund of a different sort. The First Trust High Yield Long/Short ETF will be actively managed, pursuing a “130/30” strategy. As such, the portfolio’s managers will be less concerned with hedging out interest rate risk and more interested in alpha generation and beta control.

In a 130/30 play, managers typically start by ranking target securities for their alpha generation potential. The highest ranking securities are purchased in weights that, in the aggregate, amount to 130 percent of the fund’s assets. The excess 30 percent investment is financed by short sale proceeds of the manager’s lowest-ranked issues. Thus, the portfolio’s net investment is 100 percent of its assets, but allows the managers to extract alpha from issues that are expected to lag, as well as outperform, the benchmark. Typically, the mix of long and short positions produces a net 1.00 beta.  

Lest you think the risk is caused by the market alone, keep in mind that the fund sponsors carry some, too. Their primary concern is that nobody’s interested in buying these new wares. There’s no hedge for that.