Is This 'Auto-Hedge' Worth the Risk?

A look at the Barclays S&P VEQTOR ETN (VQT), which adjusts based on the S&P 500 Index (SPX)

Jul 20, 2015 at 10:20 AM
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With the benefit of hindsight, you'd know that the first six-plus months of 2015 would morph into the Golden Age of Churn. But let's say you knew that in advance of this year. I'm not talking about having the equivalent of Biff Tannen's Almanac for stock prices. Rather, what basic strategy would you employ knowing it was a year of unsustainable moves in both directions? 

You would certainly sell straddles and strangles, and you wouldn't bother to aggressively hedge with the underlying stock(s). You would also likely fade the stock moves themselves and flip like crazy. 

You would stay away from volatility exchange-traded funds (ETFs), though that's good advice anyways. But what about Barclays S&P VEQTOR ETN (VQT)?

"The Barclays ETN+ S&P VEQTOR ETN tracks an index that dynamically allocates exposure between equity, volatility and cash based on market conditions.

... 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."  

You might be tempted to own it. I mean, you can ride the S&P 500 Index (SPX) between Greek Crises, and then hedge with some CBOE Volatility Index (VIX) products. And then you can theoretically go to all cash if it really gets ugly. Sounds promising.

The reality in 2015? Not so good. Here's VQT vs. the SPX this year:


It tracked well for a couple of months, than has just fallen off a relative cliff.

As I think about it, some of it makes sense. Every little volatility breakout has turned into a fake-out. Perhaps VQT has gotten a little whipsawed. But I'm not sure why it's done this relatively poorly. There just haven't even been that many fake breakouts. And the biggest ones took place in early January and just a few weeks ago. VQT seemed to handle the early January case relatively well; it didn't underperform at all and that's actually very good performance. You got some protection at no cost of "alpha." 

As to July, well, I suppose that underperformance makes some sense. SPX turned around and VQT likely went into VIX products and now can't quite catch up. 

What has me baffled is that middle part. Why did VQT do so badly in March? Volatility was meh. If it went into full hedge, then it needs to change its parameters. That wasn't a scare that required sustained protection.

All of which leads me to a similar point I always make about a product like this. It sounds interesting and great in theory. I mean auto-hedging, what could be better? But in reality, it's just a strategy, and it doesn't require much to replicate and tweak on your own. VQT will save you from big hits. But just simply going to cash when the S&P goes below the 200-day moving average will cost you some small money here and there but will save you from big hits too. I'm not recommending that, just pointing it out as an easy plan. 

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

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