When It Comes to Hedging, Simpler is Better

Even though we've seen a fairly volatile market in 2015, the net-net isn't all that impressive. We've made a somewhat noisy move to basically nowhere in 2015. It sure feels like a year where you could have added value by trading and/or more aggressively managing longer-term positions.

But alas, all trading/tweaking is not created equal. I periodically look at the Barclays S&P VEQTOR ETN (VQT), not because I find it a particularly compelling investment vehicle, but rather because it provides an interesting window into a volatility hedging strategy. Just to refresh:

"VQT's dynamic strategy aims to provide maximum equity exposure, via the S&P 500 in good times, and hedge its equity exposure in periods of high volatility. The underlying index adjusts its allocation to the S&P 500 and the S&P 500 VIX Futures Index based on 1-month realized volatility and forward implied volatility. In addition, the index moves to a full nominal cash allocation if it falls by more than 2% over 5 consecutive trading days."

In plainer English, it basically owns the SPDR S&P 500 ETF (SPY) until volatility picks up, then hedges with CBOE Volatility (VIX) futures until the market dips too much, at which point it goes to all cash. It will logically underperform in rallies and outperform (lose less) in declines. But what about a year when we're basically flat? Not good. Here's VQT in 2015 vs. the S&P 500 Index (SPX)​:

It's down 9% vs. SPX up 1.5%. I understand some underperformance this year in a fund with a strategy that essentially cuts back into weakness and then finds itself underinvested/overhedged when the market rallies. But that's some extreme underperformance. And it's really not in the time frame I would have expected.

VQT presumably got into cash at/near the bottom(s) in August/September. And as you can see above, it did in fact underperform the October rally. But that's not when the bulk of the underperformance hit. Rather, the damage was really done earlier in the year, from March right up into the August dip. Here's how that time frame looks:

And that's what I don't get. There wasn't much in the way of vol. spikes. We had a relatively modest one in June, and that was about it until mid-August. VQT should have basically just held SPX-ish (they don't hold the exact index).

I don't like the idea of owning something like this just because it's relatively easily to replicate the concept. To me, it's better to customize it to your own risk tolerance. But this is just ridiculous to underperform so badly in a five-month churn, and to me calls into question the strategy. It sidestepped the dip, of course, but at a pretty large cost. And even saying it sidestepped the dip is misleading. Even at the market's worst, SPX still lost less than VQT. All the dip did was briefly drag SPX down to VQT levels.

Want a better idea? Just buy and roll some cheap dollar out-of-the-money (OOTM) index puts. Or put on collars (long OOTM puts vs. short OOTM calls). Simple is often better.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research