that correspond generally to the price and yield, before the Fund’s fees and expenses, of an equity index called the CBOE S&P VIX Tail Hedge Index (the “Index”). The CBOE VIX Tail Hedge Index tracks the performance of a portfolio that overlays one-month 30-delta VIX calls on the S&P 500 index. 30-delta calls are chosen because they provide intermediate coverage. The calls are held to expiration and replaced by new calls, a procedure called the roll. In order to reduce hedging cost, the weight of the VIX calls in the portfolio varies at each roll depending on the likelihood that a “black swan” event is about to occur. Historically, deep market declines have been correlated with expected future volatility. They have rarely occurred at very low or very high levels of expected volatility and have been more frequent for intermediate levels up to expected volatility of around 30. Based on this, no VIX calls are purchased at the roll if expected future volatility lies outside the corridor ranging from 15 to 50. Between 15 and 30, the weight of the calls increases from 0% to 1%, and from 30 to 50, it decreases to ½%. The top weight is only 1% because with VIX options, a little goes a long way. This design is expected to provide an efficient tail risk hedge as well as a consistent benchmark for all other tail hedge strategies.
PRINCIPAL INVESTMENT STRATEGIES
The Fund will normally invest at least 90% of its net assets (plus the amount of any borrowings for investment purposes) in common stocks included in the Index.
The Fund, using an “indexing” investment approach, attempts to replicate, before fees and expenses, the performance of the Index. First Trust Advisors L.P. (“First Trust”), the Fund’s investment advisor, seeks a correlation of 0.95 or better (before fees and expenses) between the Fund’s performance and the performance of the Index; a figure of 1.00 would represent perfect correlation.
The Index is owned and was developed by Standard & Poor’s Financial Services LLC (“S&P” or the “Index Provider”). The Index Providers has contracted with Standard & Poor’s to calculate and maintain the Index. The Index is designed to provide a benchmark for investors interested in hedging tail risk in an S&P 500 portfolio. Index components are reviewed quarterly for eligibility, and the weights are re-set according to that distribution. As of ____________, 2011 the Index was comprised of __ securities.
The portfolio will consist primarily of equity securities designed to track the performance of the S&P 500 with a variable option overlay consisting of one-month call options on the VIX Index; however, at times, the portfolio may be comprised entirely of stocks in the S&P 500, as dictated by the Index construction methodology. The VIX Index is a measure of estimated near-term future volatility based upon the weighted average of the implied volatilities of near-term put and call options on the S&P 500. The exact composition and extent of the overlay will depend upon market volatility.
Tail hedging, in the context used by the Index Provider, is the practice of trying to hedge the portfolio from extreme market moves that are the result of random, unexpected, and unpredictable events. Unexpected events of this nature often result in rapid increases in market volatility, both realized and implied volatility. The Fund will utilize a tail hedging strategy which attempts to profit from the sudden rise in implied volatility due to any unexpected event. The gains from the “tail hedge” would then hopefully offset some of the losses incurred in the common stock portfolio due to the unexpected events.
The Fund may sell covered call options, which enables the purchaser to elect to receive a security at a predetermined price and time. A call option written by the Fund on a security is “covered” if the Fund owns the security underlying the call or has an absolute and immediate right to acquire that security without additional cash consideration upon conversion or exchange of other securities held by the Fund. A call option is also covered if the Fund holds a call on the same security as the call written where the exercise price of the call held is (i) equal to or less than the exercise price of the call written or (ii) greater than the exercise price of the call written, provided the difference is maintained by the Fund in segregated assets.
The Fund intends to invest entirely in the Index, however, there may also be instances in which the Fund may be underweighted or overweighted in certain securities in the Index, not invest in certain securities included in the Index, purchase securities not in the Index that are appropriate to substitute for certain securities in the Index or utilize various combinations of the above techniques in seeking to track the Index.
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