Equities with a Volatility Hedge: VQT

Barclays Capital recently launched an exchange traded note:  Barclays ETN+S&P VEQTOR (Symbol:  VQT).  The index underlying this note is a great concept.  The S&P 500 Dynamic VEQTOR Index allocates between equity and volatility based on the combination of realized and implied volatility trend decision variables.  The following comes from Morningstar’s ETF Weekly:

The ETN’s structure is as follows: When equity-market volatility is low (no volatility trend and close to no realized volatility), the equity component of the ETN can approach 100%, reaching a maximum of 97.5% of VQT. But when there is equity-market volatility with high realized volatility and an implied uptrend in volatility, VQT’s equity allocation will drop and the volatility allocation will rise. VQT also employs a “stop-loss” mechanism that shifts the entire value of the ETN–that is, both the equity and the volatility allocations–to 100% cash.

Again, the concept is great—an ETF that adapts its positioning to changing market conditions.  However, there are a couple of potential drawbacks.  First, there is already a hugely popular volatility ETF, which may limit the liquidity of VQT.  Second, this product is structured in the form of a note; an unsecured debt instrument susceptible to default by the issuing bank.  Third, and this is minor in the grand scheme of things, there will likely be a significant tracking error because it is a note and the “moving” allocation.  Finally, the mathematics that determine the weighting of the index are reactive, becoming prone to severe underperformance in a volatile volatility [sic] environment.

For the individual investor, I generally like strategic/dynamic funds whose weightings adapt—it alleviates a lot of the due diligence burden.  Target date funds are probably the most widely known example, although VQT might hold the honor of most unique.  However, my guess is that this product may cater a bit too much to the extreme occurrences of the last two years.  But I do think this is a breakthrough product and I look forward to future releases in the ETP space of this magnitude.

Links:
http://news.morningstar.com/articlenet/article.aspx?id=350964

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