Stocks quoted in this article:
Whatever your opinion now, we can probably all agree that risk has increased.
So, what to do? Brendan Conway takes up the topic in Barron's (subscription required), and reminds me of an interesting ETF.
The $623 million Barclays S&P 500 Dynamic Veqtor ETN (VQT), for instance, uses a complex formula to shift money between stocks, cash, and volatility futures. It shone brightly in a rough 2011.
What is that complex formula?
VQT defaults to long SPDR S&P 500 ETF Trust (SPY), but reacts to pops in volatility by purchasing CBOE Volatility Index (VIX) products. And then, in the worst case, it sells everything and goes into cash. It's like having stops at different trigger points.
Sounds great, right? Well …
The trouble here is trusting the engineering. Buyers sign on to a complex index in a product conceived after the financial crisis. That's a bigger problem than it first appears. Fund makers have strong incentives to sell you yesteryear's winners; investors' natural instinct is to hew to just those strategies. But that may not work out, argues Morningstar strategist Samuel Lee. Paradoxically, the very act of sifting through historical data for the perfect hedge increases the chance you've simply found a red herring, with no guarantee it'll work next time. "You have no way of telling how much this index was tweaked before launch," Lee says. "We're only talking about this because it worked before."
That hits the nail on the head, in my humble opinion.
You can recreate this whole concept yourself. The idea of buying volatility products AFTER the horse has left the barn sounds counterintuitive on the surface. But in reality, it makes more sense than a strategy that tries to buy VIX into volatility weakness. That's because investors rarely, if ever, factor in the true cost of all the bad volatility purchases before the one good one. Paying up when you actually need the protection and then selling at a probable loss when you find out you didn't need it sounds awful, but I can pretty much guarantee it costs less than, say, rolling out-of-the-money (OOTM) VIX calls over and over and over again. And it still sets you up with protection for that occasional instance where you really do need it.
So, to me, the issue is exactly as the highlighted paragraph states. Why trust the particular and rigid formula used by VQT as opposed to using your own eyes and ears and risk tolerance? Pretty much 100% of ETPs came to market with backtests that proved they worked. Unfortunately, nothing ever plays out exactly as it did in the past.
The performance picture of something like VQT is pretty straightforward. It's going to underperform in a generally up market, as it's going to blow money on ultimately unnecessary VIX products here and there. And it's going to lose less on market declines, thanks to buying volatility and then possibly switching to cash.
Thing is, though, you can pretty easily replicate these concepts. If you're an active trader/investor, you can just slap on the hedges yourself, when needed. And if you're a more passive investor, you just need to allocate a lower percentage into the market.
I do like the whole thought process behind VQT. It certainly beats the iPath S&P 500 VIX Short-Term Futures ETNs (VXX) of the world. It's just a question of why you need an ETF for something that's relatively easy to replicate on your own.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.