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By Jessica Rabe and Rob Martorana

Background

The Barclays S&P 500 Dynamic VEQTOR ETN (NYSEARCA:VQT) dynamically allocates between the S&P 500, S&P 500 VIX Short-Term Futures Index, and cash. Consequently, the fund provides broad equity market exposure with an implied volatility hedge by following rules-based signals. When volatility trends downward, the VEQTOR Index increases its exposure in equities (maximum 97.5%), while trimming its exposure in volatility futures (minimum 2.5%), and vice versa in times of high volatility (with a minimum equity exposure of 60%, and maximum volatility exposure of 40%). When neither exposure proves viable, or if the VEQTOR Index falls by more than 2% for five days, the fund shifts to 100% cash.

Ultimately, VQT acts as a short position in SPY during bear markets, and while it lags SPY in bull markets, the index typically achieves positive market returns with lower standard deviation to boot. One exception occurred from March 1, 2012 to October 1, 2012, when the SPY rose 5% and the VQT fell 4%. This is indicative of the VQT's uncorrelated returns. The VQT is based on the S&P 500 Dynamic VEQTOR Index (SPVQDTR). Morningstar benchmarks VQT against their multi-alternative category, while Barclays uses a proprietary benchmark.

VQT's role in RBI Portfolios

Right Blend Investing uses an endowment approach that combines ETFs and alternatives, which we described in this article. VQT is particularly attractive as a diversifier for small accounts, since it dynamically shifts asset allocation with minimal costs to the investor. Moreover, VQT allows investors to gain volatility exposure over long holding periods, while avoiding the active management required by using products such as iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX). The VXX often has a negative roll yield when volatility futures are in contango, as we noted here.

As illustrated in the exhibit below, Right Blend Investing categorizes certain alternatives as either equity complements or fixed income complements. So rather than viewing alternatives as a monolithic asset class, sometimes it makes more sense to view the holdings in terms of the stock/bond mix. (This pie chart is meant ONLY as an illustration of a concept; it is not an investment recommendation nor does it represent a model portfolio or client account.)

VQT qualifies as an equity complement, since it helps diversify the equity portion of the portfolio. In fact, the "right blend" necessitates exposure in both VQT and SPY, as noted by Fred Piard. We believe that VQT's ideal role in the portfolio is as an equity diversifier, and is best used in conjunction with SPY.

Meanwhile, PIMCO's Unconstrained Bond Fund (PFIUX) would be an example of an alternative asset that acts as a complement to the portfolio's fixed income holdings. PFIUX acts more like a diversifier than a hedge, (since that would require an inverse bet on duration via a bear-market ETF).

Hedging Against Brinkmanship

With another round of Congressional brinkmanship on the horizon, and with tensions over Fed tapering, VQT remains an attractive option. VQT's ability to capitalize on short-term market volatility spurred by Congressional distress and Federal Reserve uncertainty could prove to be an attractive hedge in coming months.

Although positive manufacturing data has boosted the chance of Fed tapering in December, tepid jobs growth and contentious budget deadlines for Congress could push it off until next year. Given the historic pattern of 11th hour congressional deals, I'd hazard that the budget committee could not only miss its December 13th deadline, but it may also push off a deal until January 15th, when the U.S. exhausts its funding, or February 7th, when the debt-ceiling will need to be raised yet again. Should this all-too-familiar scenario materialize, a spike in the VIX could arise, presenting the conditions that VQT seeks to exploit.

An Alternative to VQT

A robust alternative to VQT is PowerShares S&P 500 Downside Hedged Portfolio (NYSEARCA:PHDG), which is also based on the S&P 500 Dynamic VEQTOR Index. PHDG is a newer product, introduced in December 2012, and an exchanged-traded fund, whereas VQT dates back to August 2010, and is an exchange-traded note. The benefit of PHDG is that it behaves similarly to VQT, while charging a lower management fee and eliminating certain counterparty risks, as noted by Paul Britt:

"PHDG offers an immediate advantage over VQT: a lower fee. PHDG costs 39 basis points versus VQT's 95 basis points. PHDG's ETF structure also eliminates the counterparty risk that's baked into all ETNs: VQT is backed solely by the credit of its issuer, Barclays Bank."

Due to these advantages, RBI is considering a long position in PHDG, in place of VQT. While Britt remained bearish on PHDG due to the tracking error of an ETF vs. an ETN, his article was released shortly after the fund's inception last year. BHDG has traded within a 1% margin of VQT's returns, as seen in the below chart. RBI is considering PHDG as a more cost-effective option, and with less counterparty risk. PHDG would still fulfill the role of an equity complement, with a similar risk/return profile to VQT.


(Click to enlarge)

Source: The Role Of VQT And PHDG In Diversified Portfolios