By
Morningstar
:
By Timothy Strauts
It is 2012, but investors are still reeling from the
confidence-sapping effects of the 2008 financial crisis. Despite
the great equity returns of the past three years, investors as a
group have shied away from the stock market. In response to these
fears, demand for alternative investments that produce more
consistent returns with less risk has skyrocketed. The main
downside to most alternatives is that, while they have low risk,
they often produce low returns to match.
Barclays S&P 500 Dynamic VEQTOR ETN (
VQT
)
is among a new breed of investments that use dynamic asset
allocation to reduce risk in a portfolio but attempt to produce
equity-like returns. Many alternative funds seek to mitigate
volatility by going long and short at the same time. VQT takes a
different approach by dynamically shifting its exposure among the
S&P 500 Index, S&P 500 VIX Short-Term Futures Index, and
cash, depending on market volatility. The overall effect is a
portfolio with below-average risk that can actually rise in a down
stock market.
How It Works
Because VQT uses VIX to partially hedge against future downturns,
we must first understand the unusual mechanics of this exotic
vehicle. S&P 500 VIX Short-Term Futures Index provides exposure
highly correlated to the volatility of the S&P 500. Volatility
jumps in tandem with stock price crashes, spiking whenever the
stock market collapses. Expected volatility, thus, serves as a
proxy for market uncertainty, affording the VIX Index its common
moniker of "The Fear Index." VIX futures prices are based on the
prices of S&P 500 options. When the market expects higher
volatility, options prices go up in value because there is a higher
probability that the option will expire in the money.
This relationship between volatility and price makes vehicles
that follow the VIX good diversifiers for equity-based portfolios.
Some assets, like commodities and government bonds, show near-zero
correlation, but volatility has a strong negative correlation with
stock prices. When stocks are falling volatility usually rises
dramatically.
VQT tracks the S&P 500 Dynamic VEQTOR Total Return Index. To
determine the relative weightings of the components, there is an
allocation process. First, the current direction of volatility is
determined. Volatility is either in an up-trend, down-trend, or no
trend. An up-trend is when five-day implied volatility is greater
than 20-day implied volatility for at least 10 consecutive days. A
down-trend is the opposite condition, and no-trend is when there
haven't been 10 consecutive days of any trend. The trend is
important because volatility trends very strongly. If it has risen
recently, it is likely to continue rising, and conversely if it's
falling, it will likely continue falling. If the trend is up you
want a higher percentage volatility allocation, and if the trend is
down you want to reduce exposure to volatility.
The second step is to look at the current realized volatility.
If current volatility is high, you want a higher exposure to VIX,
and when it's low you'll want a lower allocation. Based on current
volatility and the volatility trend a target allocation to
volatility is determined that adjusts daily based on current
readings. Because volatility can move very quickly there is a built
in stop-loss feature to VQT. If the five-day return of the index is
ever less than negative 2%, the allocation switches to 100% cash
and stays there until the five-day return rises above negative
2%.
As an ETN, VQT has the credit risk of Barclays Bank which is
rated AA- by Standard & Poor's. While credit risk is a concern,
there are tax advantages to the ETN structure. Under current rules
investors are subject to capital gains tax based on the investor's
holding period. VQT does not distribute income so an investor could
theoretically hold VQT for 10 years paying tax only at the end and
get long-term capital gains treatment.
The Proof Is in the Pudding
Since its inception in August 2010, VQT has returned 35%, which is
slightly better than the S&P 500's return of 33%. It is
impressive that during a strong bull market that VQT could keep
pace with the S&P 500. A closer examination of the returns
shows the different ways the two got to where they are.
From VQT's inception to July 22, 2011, the S&P 500 was up
30%. Over the same period, VQT was up only 10%. In the strong bull
market, VIX futures dropped dramatically and because VQT maintains
a small allocation to volatility as a hedge its performance was
hurt by losses in the volatility hedge. While VQT's performance was
disappointing compared with the S&P 500, it did great when
compared with its counterparts in the multi-alternative Morningstar
category. Over the same period the multi-alternative category
returned only 6%.
After July 22, 2011, the market dropped suddenly as concerns
about the European debt crisis pushing the world into another
recession ran high. From July 22 to today, the S&P 500 has
risen only 4% but VQT has skyrocketed 22%. As the S&P 500 was
falling, volatility rose dramatically and VQT was able to take
advantage. The allocation to volatility rose at one point to the
maximum of 40%. Because the strategy is able to change its
positions daily, it was able to react effectively to the quickly
changing market environment.
One of benefits of the dynamic allocation strategy is that it
reduces portfolio risk. Over the past one-year period, the S&P
500 has had a standard deviation of 16%, while VQT has had a
standard deviation of only 12%. For slightly lower returns
investors got a portfolio with 25% less risk.
Note of Caution
While the ETN has performed well in its short existence, it may not
always do so well. For example, the strategy will not protect
against a sudden spike in volatility such as a natural disaster or
act of war. When these events occur, the equity market is likely to
drop abruptly and the VIX rise suddenly. The ETN won't adjust its
positions until the following day when it may be too late. Also, if
there is a prolonged bull market with low volatility the small VIX
position will be a drag on returns. The strategy is also very
complex and investors should take the time to fully understand the
strategy before investing.
Fees and Alternatives
This ETN charges an annual investor fee of 0.95%. This is a high
fee but, considering the unique exposure the fund offers, we
consider it fair. Many people use VIX products to hedge their
equity portfolio, but VQT is the only fund available that combines
equities and VIX vehicles in the same investment product. If you're
only interested in a VIX vehicle to hedge your equity exposure,
consider
iPath S&P 500 Dynamic VIX ETN (
XVZ
)
.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
What Are The Insiders Buying?
on seekingalpha.com