I am not an economist quite yet, so I will refrain from passing any judgment on what the outcome or implications of this fiscal cliff situation will be. However, I will say that a strong negative reaction is possible if an adequate deal is not reached. That, combined with the looming debt ceiling deadline and the situation in Europe could make for some turbulent markets ahead. In fact, the current state of the markets is eerily reminiscent of the days preceding the debt ceiling debacle last year. Am I saying with any certainty that we will have to endure triple digit swings in the Dow again? No, but am I mildly worried about the possibility? Yes, you could say that.
If it is anything like before, many investors will attempt to time the swings in the market and hedge with volatility accordingly. Some of us will profit handsomely. Others will chase the markets and fail miserably.
But what if there was a way to time the markets without actually having to do it yourself? This is where the Barclays S&P VEQTOR ETN (VQT) comes in. VQT is an actively managed ETN which dynamically allocates between broad equity exposure (S&P 500) and volatility(short term VIX Futures). This is perfect for those of us who have neither the time nor the expertise to provide the precision which volatility products such as VXX, TVIX and UVXY demand.
VQT's target volatility allocation can be anywhere between 2.5% and 40% and is adjusted daily with respect to realized volatility and implied volatility trends. The chart below illustrates the possible target allocations under different circumstances.
The higher realized volatility is, the more exposure VQT has to volatility. In addition, if 5 day implied volatility is higher than 20 day implied volatility for 10 consecutive days it is considered to be trending up and volatility exposure is increased. Conversely, if 5 day implied volatility is lower than 20 day volatility for 10 consecutive days it is considered to be trending down and volatility exposure is reduced. What if the markets shift faster than VQT can adjust? That's where its stop loss mechanism kicks in. In the event the 5 day excess return falls more than 2%, all of VQT's asset's are converted to cash the following business day.
So how well has this strategy actually performed? The chart below illustrates the returns of VQT and the SPDR S&P 500 ETF (SPY) since VQT's inception in September 2010.
VQT performed more or less on par with the SPY in this time frame, but pay special attention to the end of July 2011. Notice how the SPY plummets but VQT suffers only a minor dip and rallies afterwards. The volatility hedge reduced the impact of the initial drop on the first day. After that, the stop-loss feature, which makes VQT less prone to sustained selloffs, kicked in. The increase in realize volatility caused VQT's target volatility allocation to increase, which allowed it to ride the surge in the VIX. Also notice how throughout the volatile markets of fall 2011, VQT remains relatively nonvolatile.
Of course there are some drawbacks. Before and after the debt ceiling debacle VQT clearly underperformed the SPY. This is because its volatility exposure is susceptible to contango in the VIX futures market, and, to a lesser extent, because it carries a higher expense ratio.
Some may say this poses a dilemma. On the one hand, if I go with VQT, I will underperform the S&P 500 if there is no rise in volatility. On the other hand, if I stick with SPY I will remain vulnerable to any market downturns. My suggestion is to just stick with SPY when things are good. If ever you find yourself losing sleep over your SPY position, swap it for VQT instead. Now may be a good time to do so, for there is a possibility markets could turn volatile, and the VIX term structure is in backwardation. That means, for the time being, VQT will outperform the SPY even without a rise in the VIX.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.